Proposed Tax Changes Negatively Affect Certain Foreign Investments in Canada
Sept 6, 2012
Canadian tax amendments proposed on August 14, 2012 (the Proposals) could adversely affect common acquisition structures for acquiring Canadian corporations with foreign subsidiaries. Investments in foreign subsidiaries by existing, foreign-controlled Canadian corporations are also affected. This summary provides a brief overview of the Proposals and common examples of where they could potentially apply. For a more detailed summary of the Proposals, see our Osler Update from August 16, 2012.
Subject to certain exceptions, the Proposals generally apply where a foreign corporation controls a Canadian corporation that makes an investment in a “foreign affiliate”. For this purpose, an “investment” in the foreign affiliate is broadly defined to include acquisitions of debt or equity securities, contributions to capital, extensions of the maturity or redemption date of debt or equity securities, and conferrals of benefits. An investment in a foreign affiliate may also include an acquisition of shares of a Canadian corporation, where more than half of the value of the Canadian corporation’s assets is comprised of foreign affiliate shares. A foreign affiliate is generally a foreign corporation in which the Canadian corporation, together with related parties, directly or indirectly owns at least 10% of the shares of any class.
If the Proposals apply to a particular investment in a foreign affiliate, the result is that the Canadian corporation is either deemed to pay a dividend to its foreign parent, or the “paid-up capital” (PUC) of the shares of the Canadian corporation is reduced. A deemed dividend would be subject to Canadian withholding tax at a rate of 25% (subject to possible reduction under an applicable tax treaty, which would typically reduce the withholding rate to 5% or 15%). A reduction in PUC may have adverse future tax consequences, as any decrease in PUC reduces the amount that the Canadian corporation can distribute to its foreign parent free of Canadian withholding tax. In certain circumstances it may be possible to elect to reduce PUC to avoid deemed dividend treatment, and to possibly reinstate any decreased PUC following certain distributions of foreign affiliate shares, or proceeds from the disposition of those shares.
Limited exceptions are provided for certain corporate reorganizations, certain investments that are sufficiently “connected” to the Canadian parent, or certain loans made in the ordinary course of business or at a rate that is not less than a prescribed rate (currently 5%, but adjusted quarterly).
The Proposals generally apply to transactions occurring after March 28, 2012, subject to limited transitional relief. Comments on the Proposals are being accepted up until September 13, 2012.
Generally speaking, the purpose of the Proposals is to prevent foreign companies from taking advantage of Canada’s foreign affiliate system in a manner that erodes the Canadian tax base. The perceived abuses which are addressed by the Proposals include the “dumping” of foreign affiliates into Canada in exchange for debt (which creates an interest deduction in Canada), as well as the use of excess cash generated in Canada to fund foreign affiliates whose business is unrelated to the Canadian operations, instead of distributing the cash to the foreign parent and paying the associated dividend withholding tax. However, the Proposals are extremely broad and could negatively impact many common acquisition structures involving foreign acquirors and Canadian targets. Acquisitions in the natural resource sector (mining, oil and gas) are particularly vulnerable, since Canadian targets in this sector often derive the majority of their value from foreign subsidiaries. The following examples illustrate the manner in which the Proposals can potentially apply.
- Foreign Subsidiary Investment
A foreign controlled Canadian corporation makes an investment in one of its existing foreign affiliates (such as on a share subscription, capital contribution, loan, benefit conferral, debt assumption or extension of the maturity of existing debt). Any such investment could result in a deemed dividend to the foreign parent or a reduction of the PUC of the shares of the Canadian corporation held by the foreign parent, depending on the circumstances.
- Transfer of Shares of Foreign Corporation to a Canadian Corporation
A foreign parent transfers shares of a foreign subsidiary to its controlled Canadian subsidiary in exchange for shares. In this case, the Proposals generally deny the foreign parent the increase in PUC of the shares of the Canadian corporation that would otherwise have resulted from the contribution of the foreign corporation shares. Accordingly, the Proposals will reduce the amount that the Canadian corporation can distribute in the future to the foreign parent free of Canadian withholding tax as a return of capital distribution or on a share redemption. If the consideration for the transfer is debt, the amount of the debt is treated as a deemed dividend to the parent and is subject to Canadian withholding tax.
- Private Equity Fund Using Holding Corporation to Invest in Canadian Target
A private equity fund forms a foreign holding corporation (Holdco) which in turn forms a Canadian acquisition company (AcquireCo) to purchase a Canadian target corporation. More than 50% of the value of the Canadian target’s assets is attributable to shares of foreign affiliates at the time of the investment. The Proposals generally deem the acquisition of the shares of the Canadian target by AcquireCo to be an “investment” by AcquireCo in the foreign affiliates of the Canadian target. AcquireCo may therefore be deemed to have paid a dividend to Holdco that is subject to Canadian withholding tax, or the PUC of the AcquireCo shares may be reduced on the acquisition, depending on the circumstances.
- Foreign Takeover of Canadian Target
A foreign corporation forms a Canadian acquisition company (or uses an existing Canadian subsidiary) (AcquireCo) to buy shares of a Canadian target. More than 50% of the value of the Canadian target’s assets is attributable to shares of foreign affiliates at the time of the investment. The Proposals generally deem the acquisition of the shares of the Canadian target to be an “investment” by AcquireCo in the foreign affiliates of the Canadian target. AcquireCo may therefore be deemed to have paid a dividend to the foreign parent that is subject to Canadian withholding tax, or the PUC of the AcquireCo shares may be reduced on the acquisition, depending on the circumstances.
- Canadian Takeover of Foreign Target
A foreign controlled Canadian corporation acquires the shares of a foreign target corporation. The acquisition could result in a deemed dividend to the foreign parent or a reduction of the PUC of the shares of the Canadian corporation held by the foreign parent, depending on the circumstances.
- Canadian IPO or Other Share Acquisitions
A Canadian corporation (Canco) offers shares to the public pursuant to an initial public offering (IPO), or shares of Canco are otherwise issued or transferred. More than 50% of the value of Canco’s assets is attributable to shares of foreign affiliates. If a purchaser of Canco shares is a foreign controlled Canadian corporation (the Canadian Purchaser) that acquires or holds more than 10% of the shares of any class of Canco as part of the same series of transactions as that acquisition of Canco shares, the Proposals could apply to deem the Canadian Purchaser to have paid a dividend to its foreign parent or to reduce the PUC of the shares of the Canadian Purchaser.
For further details, including possible steps that can be taken to mitigate the impact of these rules, please contact a member of our National Tax Department.