Certain passive or Canadian-source income earned by a controlled foreign affiliate of a Canadian resident taxpayer is considered foreign accrual property income (FAPI) and is taxable in the hands of the Canadian taxpayer on an accrual basis.
Canadian risks are risks in respect of Canadian resident persons, property situated in Canada, or businesses carried on in Canada. Income from the insurance of Canadian risks is FAPI, where 10 per cent or more of the gross premium income (net of reinsurance ceded) of a foreign affiliate is premium income from Canadian risks.
Enlightened taxpayers engage in “insurance swaps”, feebly and shabbily designed to circumvent this rule, by purporting to transfer Canadian risks, originally insured in Canada, to a wholly-owned foreign affiliate of the taxpayer. The Canadian risks are then exchanged with a third party for foreign risks that were originally insured outside of Canada, while ensuring that the affiliate’s overall risk profile and economic returns are essentially unchanged.
Budget 2014 proposes to amend the existing anti-avoidance rule in the FAPI regime relating to the insurance of Canadian risks. The revised rule will apply where:
- taking into consideration any arrangements entered into by the foreign affiliate (or a person not dealing at arm’s length with the affiliate), the affiliate’s risk of loss or opportunity for gain in respect of foreign risks can reasonably be considered to be determined by reference to the returns from other risks (the tracked risks) that are insured by other parties; and
- at least 10 per cent of the tracked risks are Canadian risks.
Where the new rule applies, the affiliate’s income from the insurance of the foreign risks and any income from a connected arrangement will be included in computing its FAPI. This measure will apply to taxation years that begin on or after February 11, 2014.
Offshore Regulated Banks
Income from an investment business carried on by a foreign affiliate is included in the affiliate’s FAPI. An investment business is generally a business the principal purpose of which is to derive income from property. There is a regulated foreign financial institution exception, for a business carried on by a foreign affiliate as a foreign bank, a trust company, a credit union, an insurance corporation or a trader or dealer in securities or commodities. These activities must be regulated in the country in which the business is principally carried on, or another relevant foreign jurisdiction.
Certain clever Canadian taxpayers that are not financial institutions purport to qualify for the regulated foreign financial institution exception by establishing foreign affiliates and electing to subject those affiliates to foreign regulation. The main purpose of these affiliates is often to engage in proprietary activities, i.e., to invest or trade in securities on their own account (or those of group members, presumably), and not to facilitate financial transactions for customers.
Budget 2014 adds new conditions, making the regulated foreign financial institution available only where the following conditions are satisfied:
- The relevant taxpayer (i.e., the Canadian taxpayer of which the foreign corporation is a foreign affiliate) is (i) a Schedule I bank, a trust company, a credit union, an insurance corporation or a resident trader or dealer in securities or commodities, and supervised by the Superintendent of Financial Institutions or a similar provincial regulator, (ii) a wholly-owned subsidiary of such an institution, or (iii) a corporation that wholly owns such an institution (and is also subject to regulation).
- More than 50 per cent of the total taxable capital employed in Canada of the taxpayer and all related Canadian corporations is attributable to taxable capital employed in Canada of regulated Canadian financial institutions. Certain regulated Canadian financial institutions that have with equity of at least $2 billion, and certain affiliates, will be deemed to satisfy this second condition.
Satisfying these new conditions will not guarantee that income of a foreign affiliate from proprietary activities will be considered active business income. The affiliate also must carry on a regulated foreign financial services business, as required under the existing law, and the proprietary activities must comprise part of that business.
Stakeholders are invited to submit comments concerning the scope of this measure by early April 2014.
The thin capitalization rules in the Income Tax Act limit the deductibility of interest expense of a corporation or a trust, where debt owed by the debtor to specified non-residents exceeds a 1.5-to-1 debt-to-equity ratio. In the case of a corporation, the rules apply to debts owing to a specified shareholder, i.e., a non-resident person who, together with persons with whom the specified shareholder is not dealing at arm’s length, owns shares representing at least 25 per cent of the votes or value of the corporation. The rules also apply to debts owing to any other non-resident who does not deal at arm’s length with a specified shareholder.
In the case of a trust, the rules apply to debts owing to a specified non-resident beneficiary, and to debts owing to any other non-resident who does not deal at arm’s length with a specified beneficiary.
Part XIII of the Income tax Act also generally applies a 25-per-cent withholding tax (unless reduced by tax treaty), on interest paid or credited by a Canadian resident to a non-arm’s length non-resident. Withholding tax also applies to payments and credits by a non-resident, if the interest is deductible in computing taxable income earned in Canada.
Taxpayers trying to be clever have sought to avoid these rules, through “back-to-back loan” arrangements, interposing a third party (e.g., a foreign bank) between two related taxpayers (such as a foreign parent corporation and its Canadian subsidiary). Budget 2014 adds a specific anti-avoidance rule in respect of withholding tax on interest payments, and amends the existing anti-avoidance provision in the thin capitalization rules. Under the proposed rule, a back-to-back loan arrangement will exist where, as a result of a series of transactions, the following conditions are met:
• a taxpayer has an outstanding interest-bearing obligation owing to a lender (the intermediary); and
• the intermediary or any person who does not deal at arm’s length with the intermediary
- is pledged a property by a non-resident person as security in respect of the obligation (a guarantee, in and of itself, will not be considered a pledge of property),
- is indebted to a non-resident person under a non-recourse debt, or
- receives a loan from a non-resident person on condition that a loan be made to the taxpayer.
Where a back-to-back loan arrangement exists, appropriate amounts in respect of the obligation and interest will be deemed owing to the non-resident person for purposes of the thin capitalization rules, generally in an amount equal to the lesser of:
- the outstanding obligation owing to the intermediary; and
- the fair market value of the pledged property or the outstanding amount of the debt for which recourse is limited or the loan made on condition.
The taxpayer will also be deemed to have an amount of interest payable to the non-resident person equal to the proportion of the interest on the obligation owing to the intermediary that the deemed amount owing is of that obligation.
Withholding tax will generally apply in respect of a back-to-back loan arrangement to the extent that it would otherwise be avoided by virtue of the arrangement.
The new rules will apply (i) in respect of the thin capitalization rules, to taxation years that begin after 2014, and (ii) in respect of withholding tax, to amounts paid or credited after 2014.
Consultation on tax planning by multinational enterprises
The Organisation for Economic Co-operation and Development has launched a bright new project aimed at addressing “base erosion and profit shifting” (BEPS) strategies used by multinational enterprises (MNEs). The OECD and the G-20 are working together on the issues identified in the BEPS Action Plan, released July 2013.
The enlightened Department of Finance invites input on the following, often-excessively general and conceptual questions:
• What are the impacts of international tax planning by MNEs on other participants in the Canadian economy? How to ensure fairness among different categories of taxpayers ? (e.g., MNEs, small businesses and individuals)
• Which of the international corporate income tax and sales tax issues identified in the BEPS Action Plan should be considered the highest priorities for examination and potential action by the Department? The Department pointedly notes that in some countries (e.g., South Africa and the European Union), foreign-based vendors must register and charge sales taxes if they make e-commerce sales to local residents.
• Are there other corporate income tax or sales tax issues related to improving international tax integrity that should be of concern to the Department?
• What considerations should guide the Department in determining the appropriate approach to take in responding to the issues identified – either in general or with respect to particular issues?
• Would concerns about maintaining Canada’s competitive tax system be alleviated by coordinated multilateral implementation of base protection measures?
Consultation on Treaty Shopping
Related to the above general international tax consultations, Budget 2013 set out the government’s concerns over “treaty shopping”, i.e. clever arrangements under which a person not entitled to the benefits of a particular tax treaty with Canada uses an entity resident in a state with which Canada has a tax treaty, to obtain Canadian tax benefits. Budget 2013 announced consultations regarding possible approaches to address treaty shopping. A consultation paper was released in August 2013, with request for comments.
Treaty shopping was also targeted in the above OECD Action plan of July 2013. The Action Plan calls for the development of “model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances”. The OECD is expected to issue its recommendations in September 2014.
Most countries that have addressed the issue in their tax treaties have used a general rule that denies a tax treaty benefit if one of the main purposes for entering into a transaction is to obtain the benefit. Some countries (e.g., the United States and Japan) have more detailed and specific rules.
Canada has included a main purpose rule in several of its tax treaties, as have several other countries. Stakeholders expressed concerns that a general approach might produce less certain outcomes in some cases (compared to a more specific approach). The Department responds that the U.S. limitation on benefits provision does not capture all forms of treaty shopping, e.g., arrangements that use certain entities, such as publicly-traded corporations or trusts.
Several stakeholders expressed a preference for a solution to treaty shopping that would require the re-negotiation of Canada’s tax treaties: a domestic law response to treaty shopping would alter the balance of compromises reached in the negotiation. The Department tartly responds that domestic law provisions to prevent tax treaty abuse are not considered by the OECD or the United Nations to be in conflict with tax treaty obligations, and that other countries have enacted legislation.
Some stakeholders asserted that only a few of Canada’s tax treaties would need to be re-negotiated in order to significantly curtail treaty shopping. Ah, but then other conduit countries would emerge, responds the Department.
Not minding to short-circuit the future public comments requested, the Department announces that the main elements it wants to see in the treaty-shopping rule are the following.
• A main purpose provision: subject to the relieving provision, a benefit would not be provided under a tax treaty, if it is reasonable to conclude that one of the main purposes for undertaking a transaction (which can be part of a series of transactions or events) that results in the benefit, was for the person to obtain the benefit.
• Conduit presumption: it would be presumed that one of the main purposes for undertaking a transaction that results in a treaty benefit, was to obtain that benefit, if the relevant treaty income is primarily used to transfer an amount to another person who would not have been entitled to an equivalent or more favourable benefit, had the other person received the relevant treaty income directly.
• Safe harbour presumption: subject to the conduit presumption, it would be presumed that none of the main purposes for undertaking a transaction was to obtain a treaty benefit, if:
- the person (or a related person) carries on an active business (other than managing investments) in the treaty state and, where the relevant treaty income is derived from a related person in Canada, the active business is substantial compared to the activity carried on in Canada giving rise to the relevant treaty income;
- the person is not controlled by another person who would not have been entitled to an equivalent or more favourable benefit had she received the relevant treaty income directly; or
- the person is a corporation or a trust the shares or units of which are regularly traded on a recognized stock exchange.
• Relieving provision: if the main purpose provision applies in respect of a treaty benefit, the benefit is to be provided, in whole or in part, to the extent that it is reasonable having regard to all the circumstances.
Even if a transaction results in a tax treaty benefit, the Department generously opines that it does not necessarily follow that one of the main purposes for undertaking the transaction was to obtain the benefit. The proposed rule would not apply in respect of an ordinary commercial transaction solely because obtaining a tax treaty benefit was one of the considerations for making an investment.
The rule would apply to taxation years that commence after enactment of the rule. The Department finds rather unreassuringly that transitional relief “may” be appropriate.
The Department invites comment on five specific examples. The first example involves assignment of income. Aco, resident in State A, owns intellectual property used by subsidiary Canco, resident in Canada. State A does not have a tax treaty with Canada. Aco incorporates Bco in State B, a state with which Canada has a tax treaty that provides for a nil rate of withholding tax on royalties. Aco assigns to Bco the right to receive royalty payments from Canco. Bco agrees to remit 80 per cent of the royalties received to Aco within 30 days. Bco pays tax in State B on its net amount of royalty income. State B does not impose withholding tax on royalties.
Under the conduit presumption, in the absence of proof to the contrary, one of the main purposes for the assignment of the royalties would be for Bco to obtain the withholding tax reduction. By virtue of the relieving provision, Bco may be allowed the benefits of the treaty in respect of the portion of the royalty payments not used by Bco to pay Aco.
If, instead, only 45 per cent of the royalties received by Bco were used to pay Aco, the conduit presumption would not apply as to the main purpose of the transaction, and it would be a question of fact whether the main purpose provision applied.
The second example involves payment of dividends. Canco is owned by Bco, resident in State B. The sole investment of Bco consists of the shares of Canco. Bco was established by its two corporate shareholders, Aco and Cco, residents of State A and State C respectively. Canada has a tax treaty with State B. Canada also has tax treaties with States A and C, which provide a higher rate of withholding tax on dividends than the State B treaty rate. Bco is required to distribute the entire dividend received from Canco to Aco and Cco almost immediately. Under the domestic laws of State A and State C, dividends received from foreign corporations are subject to tax.
Under the conduit presumption, one of the main purposes for the establishment of Bco would be to obtain the withholding tax reduction under the treaty between Canada and State B. Subject to the relieving provision, the benefit would be denied. The benefits that would have applied if Bco had not been established may be provided under the relief provision, to the extent it is reasonable having regard to all the circumstances, i.e., the benefits under the tax treaty between Canada and States A and C, had the dividend been paid directly from Canco. The Department would also require in this instance that Aco and Cco be taxable on the dividends.
Example 3 involves change of residence. Aco, resident in State A, owns shares of a Canadian-resident corporation and is contemplating their sale. The sale would trigger a capital gain taxable in Canada. Canada does not have a tax treaty with State A. Shortly before the sale, Aco is continued into, and becomes a resident of, State B, a state that does not impose tax on capital gains. The tax treaty between Canada and State B provides an exemption for capital gains on shares of a Canadian corporation disposed of by residents of State B. Aco sells the shares and retains the proceeds of disposition.
Since the proceeds of disposition remain with Aco, the conduit presumption would not apply. However, the main purpose provision would still apply.
If Aco were already a resident of State B at the time of the initial acquisition of the shares, it would need to be determined whether one of the main purposes for the establishment of Aco as a resident of State B was to obtain the capital gains exemption. All the relevant circumstances would need to be considered, including, for example, the lapse of time between the establishment of Aco in State B and the realization of the capital gains, and any other intervening events.
Example 4 involves “bona fide” investments. B-trust is a widely held trust that is a resident of State B, a state with which Canada has a tax treaty. B-trust holds 10 per cent of its portfolio in shares of Canadian corporations. Under the tax treaty between Canada and State B, the withholding tax rate on dividends is reduced to 15 per cent. A majority of investors in B-trust are residents of states with which Canada does not have a tax treaty. B-trust annually distributes all of its income to its investors.
Because dividends received by B-trust from Canadian corporations are primarily used to distribute income to persons not entitled to tax treaty benefits, under the conduit presumption one of the main purposes for the structure is to obtain the benefit under the tax treaty between Canada and State B. It would have to be clearly established that none of the main purposes for undertaking these investments, either alone or as part of a series of transactions, was to obtain the benefit of the tax treaty. This could be the case here, since investors’ decisions to invest in B-trust are not driven by any particular investments made by B-trust, and B-trust’s investment strategy is not driven by the tax position of its investors.
Example 5 addresses the safe harbours for foreign active business operations. Aco is resident in State A, with which Canada does not have a tax treaty. Aco owns all the shares of Finco, resident in State B, which has a tax treaty with Canada. Finco acts as a financing corporation for Aco’s wholly owned subsidiaries, including Canco and Bco (also resident State B). Bco carries on an active business in State B, which is substantial in comparison to the activities carried on by Canco. Aco’s other subsidiaries are residents of other states with which Canada has tax treaties with benefits on payments of interest equivalent to those in the Canada-State B tax treaty. Finco receives payments of interest from Aco subsidiaries and reinvests its profits.
Since the interest payments received by Finco from Canco are primarily used to pay persons who would have been entitled to an equivalent benefit had they received the interest payment directly from Canco, the conduit presumption would not apply. The safe harbour presumption describes categories of persons who, unless they are used in conduit arrangements, are generally considered not to be engaged in treaty shopping in the course of their normal operations.