Canadian Government Proposes Significant Changes to Canada's Tax Rules

Mar 9, 2004

The Proposals revise or replace proposed amendments announced on December 20, 2002 and include significant new proposals to amend Canada's Income Tax Act, particularly the "foreign affiliate" rules. Taxpayers are advised to proceed cautiously with transactions that may be affected by the Proposals.

On February 27, 2004, the Minister of Finance released proposals to amend the Income Tax Act (Canada). Many of the Proposals will be effective as of February 27, 2004 (if not earlier) and may affect taxpayers who have completed transactions relying on earlier announcements.

This Osler Update provides an overview of some of the more significant changes included in the Proposals and comprises two parts:

1. Proposed Changes to the Foreign Affiliate Rules

2. Other Proposed Changes

1. Proposed Changes to the Foreign Affiliate Rules

Due to the broad scope of the changes in the Proposals to the foreign affiliate rules, taxpayers should be extremely cautious when undertaking any transaction that involves foreign affiliates or that may be affected by the foreign affiliate rules. In addition to the changes described below, several other amendments will affect the calculation of surplus accounts (including the treatment of deficits), the calculation of "foreign accrual property income" (FAPI), including significant changes with respect to services income earned by a foreign affiliate (such as for services provided by non-arm's length Canadian residents), and the determination of a foreign affiliate's income from depreciable property and eligible capital property. The effective dates for the proposed changes vary considerably, with some changes applying only after February 27, 2004 and others applying retroactively to earlier years (either on an elective basis or otherwise).

"Controlled Foreign Affiliate" and other Definitions

Several changes have been made to the relevant definitions that could have significant effects on the application of the FAPI rules. For example, the definition "controlled foreign affiliate" (CFA) has been amended, presumably in response to the Federal Court of Appeal's decision in Silicon Graphics? which suggested that group control required some nexus between the various members of a group. The proposed CFA definition aggregates shareholdings of a particular taxpayer and non-arm's length persons in determining control (in a manner similar to the "Canadian-controlled private corporation" definition). Moreover, the proposed CFA definition also aggregates shareholdings of up to four Canadian residents, and persons who are non-arm's length with those Canadian residents. Several attribution rules have also been proposed to "look through" ownership interests in corporations, partnerships and trusts in applying the CFA definition.

The proposed CFA definition appears unworkable in many respects. No guidance is provided to determine which four Canadian residents should be considered in applying this definition. Moreover, the attribution rules and the inclusion of non-arm's length persons of other Canadian residents may make it impossible, in some circumstances, to determine whether a foreign affiliate is a CFA (as Canadian investors may not have access to the information required to make such determinations).

"Surplus Suspension" Rules

The Proposals contain complex rules that are intended to prevent or defer the recognition of exempt and taxable surplus on certain intra-group asset and share transfers by a foreign affiliate. These rules replace controversial rules proposed on December 20, 2002 that would have deemed FAPI to arise on similar intra-group transfers of shares of a foreign affiliate, even if the transferred shares were "excluded property" (and would not otherwise have given rise to FAPI).

The proposed "surplus suspension" rules prevent a foreign affiliate from recognizing, currently, in its surplus accounts any income or capital gains arising on transfers of assets or shares that are excluded property to a "specified purchaser" (generally, another foreign affiliate or a non-arm's length person). Income and capital gains suspended under these rules may be recognized on a subsequent external disposition: generally a "triggering disposition" (e.g., a sale of the transferred property to an arm's length person that is not a foreign affiliate), or a transaction that results in the "specified purchaser" losing that status (e.g., on a sale of the purchaser to an arm's length party that results in the purchaser ceasing to be a foreign affiliate). Although the proposed rules allow current recognition of the otherwise suspended income or gains on an elective basis, any such elected income or gains are included in computing FAPI (subject to an election being made to deem the amount to be a dividend from a foreign affiliate).

"FAPI Loss Suspension" Rules

The Proposals also add rules that will suspend the recognition of losses that arise in respect of certain intra-affiliate transfers, by a foreign affiliate, of property that is not excluded property, depreciable property or eligible capital property (i.e., losses that would otherwise be available to shelter FAPI). These rules are designed to defer recognition of losses until a subsequent external disposition (which is defined in a manner similar to that under the proposed surplus suspension rules).

The surplus suspension rules and the FAPI loss suspension rules have a much lower threshold for suspending gains and losses (that is, "foreign affiliate" status) than is used in the domestic loss suspension rules (that is, "affiliated" status), and contain many special definitions applicable for certain limited purposes.

Active Business Income

Several changes have also been proposed to the rules that deem certain otherwise passive income earned on intra-group transactions to be income from an active business. A welcome change has been proposed to the rule that allows certain intra-affiliate payments of interest and other amounts to be treated as active business income. The Proposals extend that rule beyond its current application to foreign affiliates in respect of which a Canadian taxpayer has a "qualifying interest" (at least 10% of the voting shares and equity value) ? the rule will now also apply to foreign affiliates that are related to the Canadian taxpayer.

Significant relieving changes have also been proposed to another rule which includes, in active business income, interest earned on a loan to a second foreign affiliate that uses the loan to acquire shares of a third affiliate that are excluded property (provided the second and third affiliate are resident and subject to tax in the same foreign jurisdiction). The proposed amendments remove the existing requirements that the second and third affiliates be members of the same foreign tax group, and also remove requirements with respect to the character of the income earned by such affiliates.

Foreign Reorganizations

Significant changes have been proposed to the foreign affiliate reorganization rules that apply to foreign mergers and liquidations. The Act currently provides certain reorganizations with rollover treatment in respect of both excluded and non-excluded property. Among other things, the proposed amendments prevent a rollover from applying to non-excluded property transferred on a foreign merger or liquidation unless a Canadian taxpayer maintains a surplus entitlement percentage of at least 90% in the relevant foreign predecessor and successor corporations. Accordingly, under the proposed amendments, FAPI could arise on many foreign reorganizations where it would not have arisen previously.

The current rules applying to liquidations of a foreign affiliate into its Canadian parent have also been significantly amended. The proposed rules apply to any foreign affiliate (not just to a CFA), and they apply regardless of whether shares of any lower tier foreign affiliate are transferred to the Canadian parent (although rollover treatment is generally only provided for shares of lower tier foreign affiliates that are excluded property).

In addition to the proposed amendments to the existing rollover rules, the proposed rules also provide rollover treatment in respect of several other foreign reorganizations, including in respect of certain share redemptions, dividends paid in kind and returns of capital. Other changes amend the rules that apply to deemed dividend elections (for example, aggregating surpluses and deficits) and to a potential "bump" to the basis of shares of a foreign affiliate on a winding-up of its Canadian parent (for example, by reducing underlying surplus by the bump amount).

Foreign Exchange Rules

The Proposals retain most of the rules that were proposed on December 20, 2002 and that were intended to ensure consistent treatment between foreign exchange income, gains and losses on property with any income, and gains and losses on related currency hedges. The Proposals also contain a rule that prevents certain losses on shares of a foreign affiliate from being denied to the extent that they relate to offsetting currency gains realized by the Canadian corporate taxpayer on settling debt or redeeming shares that were originally issued to acquire the foreign affiliate shares. Although this proposed rule is narrower than that suggested in an earlier "comfort letter" from the Department of Finance, it is a welcome change that will be very important to offshore finance companies.

2. Other Proposed Changes

Payments for a Restrictive Covenant

Consistent with the announcement on October 7, 2003 (which is described in an earlier Osler Update titled "Non-Compete and Similar Payments Become Taxable"), the Proposals will add rules to the Act relating to restrictive covenants. Generally, the proposed rules will apply to payments received (or that are receivable) after October 7, 2003 by a taxpayer.

In general terms, the Proposals define a restrictive covenant of a taxpayer very broadly to mean an agreement or undertaking (other than for the disposition of the taxpayer's property) or a waiver of an advantage or right that affects (or is intended to affect) the acquisition or provision of property or services by the taxpayer (or by a non arm's length person), whether legally enforceable or not. As defined, a restrictive covenant is not limited to a non-competition covenant given by a vendor in connection with the sale of a property or business.

Under the proposed rules, payments for a restrictive covenant of a taxpayer that are received or receivable by the taxpayer (or by a person not dealing at arm's length with the taxpayer) will be required to be included in the taxpayer's income. However, if the taxpayer and purchaser deal with each other at arm's length, there are three important exceptions to the income inclusion rule:

  1. The amount is required to be included (or would be included if it were received in the year) in the taxpayer's employment income for the year.
  2. The taxpayer disposes of goodwill of a business and the taxpayer and the purchaser elect to treat any payment for a restrictive covenant relating to that business as part of the proceeds of disposition of the goodwill.
  3. The restrictive covenant is a non-competition covenant given by the taxpayer and is directly related to the disposition by the taxpayer of a capital property that is a partnership interest or a share of a corporation, the amount received for the restrictive covenant is included in the taxpayer's proceeds of disposition of the capital property, the partnership or corporation carries on a business, and the taxpayer and the purchaser elect to have this exception apply.

Where these exceptions apply, the tax treatment of the payer of such amounts will mirror that of the taxpayer; in other cases, the tax treatment of the payer of such amounts will depend on the application of the other rules in the Act.

The Proposals also include a rule that has not previously been announced and will apply on and after February 27, 2004 (except where the restrictive covenant was granted in writing before that day between arm's length parties). Under the proposed rule, an amount received or receivable by a taxpayer for a disposition of property may be considered as being, in part, for a restrictive covenant to the extent that it is reasonable to consider that part as being for the restrictive covenant.

Consideration for Vendor's Warranties, Covenants and Other Obligations

Under an existing rule in the Act, consideration received by a vendor for a warranty, a covenant or other conditional or contingent obligation given or incurred by the vendor in respect of a capital property disposed of by the vendor is part of the vendor's proceeds of disposition of the property; if the vendor ultimately incurs an outlay or expense under the warranty, covenant or other obligation, the vendor will incur a capital loss from a notional disposition of property. The Proposals will amend this rule for taxation years that end after February 27, 2004. The proposed rule will not apply to a restrictive covenant as defined in the Proposals (see above).

Under the proposed rule, consideration received (or receivable) by a vendor for such a warranty, covenant or obligation would only be included in the vendor's proceeds of disposition of the property if the consideration is received (or receivable) on or before the day the vendor is required to file its tax return for the taxation year in which the disposition of the property occurs. If the consideration is received (or receivable) after that day, the consideration will be treated as a capital gain from a disposition of the property that occurs at the time the consideration is received (or becomes receivable). Outlays or expenses paid (or payable) by the vendor under such a warranty, covenant or other obligation will mirror that treatment and will either reduce the proceeds of disposition or be treated as a capital loss.

The proposed rule may have adverse results (for example, where gains are realized by a vendor on a disposition of property and subsequent losses arising in respect of warranty payments are denied or restricted in some way under various loss denial, suspension or limitation rules in the Act).

Distributions of Capital by a Public Company

The Act contains a rule that deems a return of capital by a public corporation to be a dividend paid by the public corporation (subject to certain exceptions in respect of redemptions and repurchases of its shares, on a reorganization of its capital and on a winding up or reorganization of its business). The Proposals will amend the existing rule to allow a public corporation to make a payment on a reduction of capital without the payment being deemed to be a dividend in certain additional circumstances.

Under the proposed amendment, a public corporation may make a payment on a reduction of the capital of its shares (without the amount being deemed to be a dividend) out of any proceeds realized by the public corporation (or by a person or partnership in which the corporation has a direct or indirect interest) from a transaction that occurred outside the ordinary course of business. Only one such payment on a reduction of capital will be permitted in respect of a transaction and the payment must be made within 24 months after the transaction.

The proposed amendment, which is narrower than that first mentioned in a "comfort letter" issued by the Department of Finance to a taxpayer in 1998, will be applicable to amounts paid after 1996 (although some relief is provided for taxpayers who may have relied upon the "comfort letters" issued by the Department of Finance in making payments after 1996 and before February 27, 2004).

Foreign Property

The Proposals will amend the Act's definition of "foreign property" that applies for the purposes of certain limitations on foreign investments of pension funds and certain other tax exempt funds or entities. The proposed amendment will be of particular interest to taxpayers who acquire or hold a pool of mortgages in which interests are sold to tax-exempt investors as part of a securitization arrangement.

Under the proposed amendment, an indebtedness secured by a mortgage, hypothec or a similar obligation in respect of real property situated in Canada will not be foreign property if the cost amount of the particular indebtedness to the taxpayer (together with the total cost amounts to the holders of all other indebtedness in respect of the real property that ranks equally or superior to the particular indebtedness) does not exceed the fair market value of the real property (without taking into account any decline in the fair market value of the real property after the particular indebtedness was issued). This is an onerous requirement because, among other things, the taxpayer will be required to have ongoing knowledge of the total cost amount to other taxpayers of all other indebtedness secured by the property in question.

The Proposals will also amend certain rules in the Regulations that deal with qualified limited partnerships. An interest of a limited partner in a qualified limited partnership is deemed not to be a foreign property. The principal consequence of the proposed amendments is that a partnership will no longer cease to be a qualified limited partnership if the cost amount of its foreign property exceeds 30% of the cost amount of all its property. Moreover, even if the partnership fails to meet the 30% foreign property limit, specified partners of the partnership will continue to be entitled to include a proportion of their limited partnership interest (based upon the proportion of the property of the partnership that is not foreign property) as being property that is not foreign property.

Securities Lending Arrangements

Where a taxpayer lends a "qualified security" to another party under a "securities lending arrangement," the Act provides that the taxpayer is deemed not to have disposed of the security and, therefore, will not realize a gain (or incur a loss) for tax purposes. A qualified security includes shares of public corporations and certain debt obligations of public corporations and governments. The Proposals will make several amendments to the securities lending rules. Under the proposed amendments, the definition of a qualified security will be amended to include a "qualified trust unit," which is defined as unit of a mutual fund trust listed on a prescribed stock exchange. Rules are also being proposed to govern the tax treatment of compensation payments made by a borrower of a qualified trust unit to the lender in respect of distributions from the trust. The proposed amendments will apply to arrangements made after 2001.

Capital Interests in a Trust that are not Capital Property

The Proposals include amendments to the Act that will affect, retrospectively, a taxpayer who holds a capital interest in a trust but does not hold that interest as a capital property. Generally, the proposed amendments will apply in respect of such interests to dispositions occurring, and valuations made, after February 27, 2004. However, where the capital interest in a trust is a unit of a mutual fund trust that is listed on a prescribed stock exchange, the proposed rules will apply to dispositions occurring, and valuations made, after 2001.

Where the proposed amendments apply, they will have two principal consequences:

  1. The taxpayer will be required to include, in income for tax purposes at the time of the disposition of the capital interest, certain amounts that became payable to the taxpayer in respect of the capital interest after 1987 and before the disposition and that were previously not taxable to the taxpayer (for example, the non-taxable portion of capital gains and any other non-taxable returns of capital).
  2. The taxpayer will be denied an inventory deduction to the extent it is attributable to such amounts.

Foreign Tax Credits

A taxpayer's foreign tax credit generally may not exceed the taxpayer's Canadian tax otherwise payable on the relevant foreign-source income. For this purpose, foreign-source income has generally been considered to include interest earned on indebtedness of a non-resident even where such indebtedness is held by the taxpayer in its Canadian business (e.g., a loan made to a non-resident by a Canadian bank in the course of carrying on its business in Canada).

The Proposals will amend the foreign tax credit rules to ensure that this tax treatment of interest will continue. The proposed amendment will apply to interest received after February 27, 2004.

Further Information

If you have any questions regarding this Osler Update, please contact any member of our Tax Department.