Foreign affiliate update

By Trent Henry & Deirdre Choate
Illustration: Mike Constable

Proposed Amendments to the Income tax Act  include important changes to the foreign affiliate rules

On February 27, 2004 the minister of finance released a package of draft technical amendments to the Income Tax Act. A sizeable portion of the 846-page technical bill includes significant proposed changes in the foreign affiliate area. Some of the provisions reintroduce the measures contained in the December 20, 2002 draft legislation while others reflect changes arising from the subsequent consultation process. The draft amendments both revise and add to the amendments originally released in 2002.

To put the proposals in context, a quick summary of Canada’s foreign affiliate system is required. A fundamental aspect to the Canadian system is that favourable results are achieved when foreign affiliate status is achieved. This is accomplished because dividends paid out of the exempt surplus of a foreign affiliate are effectively exempt from Canadian tax. (Canada allows a credit for underlying foreign tax in respect of dividends paid of taxable surplus.) Other countries have exemption systems for dividends received from foreign affiliates. However, few require the tracking of surplus accounts. Given Canada does, there can be significant value to generating surplus. Many countries, such as the US, have a foreign tax credit system in place. These countries typically include any dividends in income and allow a credit for the related underlying foreign tax.

Another fundamental concept of the Canadian system is that Canadian shareholders of controlled foreign affiliates (CFA) are required to include in income on a current basis its share of foreign accrual property income. FAPI is generally passive income or income deemed to be passive. (The US has similar rules, commonly referred to as the CFC-Subpart F rules.)

The February package includes a significant number of technical changes, some of which Finance had previously discussed in a number of its comfort letters. Fundamentally, the most significant item in the package is a new regime that targets the perceived problem of premature or inappropriate realization of foreign surplus accounts. This new regime is the result of the highly criticized December 2002 proposed solution to premature realization of surplus that created FAPI on many internal transactions.

The coming-into-force provisions vary considerably with certain changes applying after February 27, 2004 and others after December 20, 2002. Provisions that are part of the Global Section 95 Election would apply to taxation years after 1994 of all foreign affiliates of the taxpayer.
The new proposals provide for a three-year period in which the taxpayer can revoke the global election, thereby avoiding being worse off for having made the election. The application date of each relevant provision should be reviewed carefully.

Given the extent of the amendments proposed in respect of the foreign affiliate rules, this is not a detailed or comprehensive analysis, merely highlights of more important changes.

Changes to controlled foreign affiliate and other definitions
Proposed is a new definition of CFA that would apply for the taxation years of a foreign affiliate of a taxpayer that begin after 1995.

The new definition aggregates not only shares held by four other Canadian residents but also persons not dealing at arm’s length with those other residents. Also, attribution rules that would treat a taxpayer as owning a proportion of shares owned by a corporation, trust or partnership of which it is a shareholder, beneficiary or member have been proposed.

The definition of “excluded property” is to be amended. This definition is relevant for purposes of computing the FAPI and the tax surpluses and the deficits of a foreign affiliate. The definition of FAPI will also change to include gains on certain transfers of excluded property.

Suspended gains and losses
These new proposals appear to be intended to ensure that various inter-company or internal transactions do not give rise to the recognition or duplication of surplus or the elimination of deficits. 

There are two sets of suspended gain rules, one for shares that are excluded property and one for other excluded prop-erty. Generally, a capital gain that would otherwise arise on an internal disposition (the meaning of internal is based on the definitions of “specified vendor” and “specified purchaser”) by a foreign affiliate of a share of another foreign affiliate would be suspended until there is a triggering disposition or the holder ceases to be a specified purchaser (for example, a sale outside the group to a third party). A similar rule will suspend income and gains realized on the internal disposition of excluded property other than foreign affiliate shares.

There is also a proposed suspended loss rule for dispositions of property other than excluded property, depreciable property or eligible capital property.

Foreign reorganizations
Numerous changes have been proposed to the foreign affiliate reorganization rules that apply to foreign mergers and liquidations. Subsection 88(3) currently provides for an elective rollover where, on the dissolution of a CFA, shares of another foreign affiliate have been disposed of to the Canadian taxpayer (i.e., first-tier liquidations). The proposed changes would ex-pand the scope of this subsection to apply to dispositions of property by any foreign affiliate, not just a CFA, and as payment in kind in respect of share redemptions, dividends and other forms of distributions by the disposing affiliate. An elective roll-over applies to the distribution of excluded property consisting of shares of another foreign affiliate. For all other property, a fair market value disposition is prescribed. The proposals also address the amount and character of the distribution. The amount of a dividend or distribution of property, or the amount of the proceeds of share redemption, would be deemed to be equal to the amount of the disposing affiliate’s proceeds of the distributed property. Where there is a distribution of property other than as a dividend or as redemption proceeds, the portion regarded as a return of the original share issuance price or contributed surplus would reduce the adjusted cost base of the shares, while any balance would be included in income.

For lower-tier liquidations and foreign mergers, the existing reorganization provisions would be amended to apply to all types of property, not just capital property, and to property of certain merged affiliates even when there is no disposition of that property under the relevant foreign law. In the case of affiliates less than 90%-owned, an elective rollover will apply to all property of the predecessor or liquidating affiliates that is excluded property, but accrued income or gains on all other property would be, or be deemed to be, realized. Any income or gain realized by the disposing affiliate would be included in computing its FAPI and could not be reduced by making a subsection 93(1) election.

At the shareholder level, in the case of less than 90%-owned foreign affiliates, an elective rollover will generally apply where the shares of the predecessor or liquidating affiliate are excluded property. Any income or gain realized by the shareholder would be included in computing its FAPI, but a subsection 93(1) election would be avail-able. In the case of 90%-owned affiliates, an elective rollover would apply for mergers, but a forced rollover would apply to liquidations, and a subsection 93(1) election would be available.

There are other significant changes to the rules relating to liquidations and dissolutions of foreign affiliates, including an amendment to Regulation 5905(7) that would ensure proportionate amounts of any deficits of a liquidating affiliate would flow through to the foreign affiliate shareholders of the liquidating affiliate. Also, a limitation on the paragraph 88(1)(d) bump is proposed with respect to foreign affiliate shares. The potential bump would be reduced by dividends received on the shares that are deductible under section 113, except to the extent that the dividends are attributable to post-acquisition of control surplus balances.

Subsection 93(1) Elections
The proposals contain extensive changes to the rules relating to section 93 elections. As noted, a subsection 93(1) election would generally not be available in respect of dis-positions of property by a merging, liquidating or distributing affiliate, but would be applicable in respect of dispositions at the shareholder level. The amount of the surplus available to be deemed to be a dividend is to be determined by consolidating all of the surplus and deficit accounts (referred to as “consolidated net surplus”) in the relevant foreign affiliate chain. In ad-dition, a new adjustment rule would reset the surplus and other balances of the relevant affiliates following a subsection 93(1) election and another rule would provide for share basis adjustments in respect of shares of those lower-tier affiliates whose balances were reset.

Proposed subsection 93(1.4) would provide that no section 93 election may be made in respect of dispositions of shares of a foreign affiliate if a number of the rules of reorganization apply to the disposition.

Financing foreign affiliates
Most of the changes in the financing area were anticipated as a result of comfort letters issued by Finance. As expected, the proposals include significant amendments to the rule in clause 95(2)(a)(ii)(D) that applies to deem interest income received by a lender foreign affiliate to be active business income when the debtor affiliate (acquiror) uses the funds to buy the shares of a third foreign affiliate (target). The new rules will no longer require the acquiror and target to be part of a foreign consolidated group. Further changes include the elimination of the requirement that the Canadian taxpayer have a qualifying interest in the target, provided the taxpayer and target are related, and the introduction of rules to accommodate tiered holdings through flow-through entities such as LLCs. The new rules may apply retroactively if the taxpayer chooses, but are no longer part of the Global Section 95 Election.

Conclusion
Taxpayers were invited to comment on the proposals so it’s expected there will be further changes to the legislation before it is introduced as a technical bill. However, taxpayers need to be aware of the impending changes and plan accordingly. Also, previous transactions should be analyzed in light of the proposed changes and their respective coming-into-force provisions.