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By Loren D. Kroeker
Illustration: Carey Sookocheff
 A PRACTICAL FRAMEWORK TO THE PROPOSED NEW RULES, WHICH ARE VERY COMPLEX AND FAR-REACHING
On October 11, 2002 the Department of Finance released another round of draft legislation on foreign investment entities (FIEs) and nonresident trusts. The stated intention of the proposed legislation is to make the Canadian income tax system fairer and to prevent tax avoidance by those taxpayers who invest in or otherwise transfer property to offshore trusts or funds.
These proposals were announced in the 1999 federal budget and the original draft legislation was introduced on June 22, 2000 and was to be applicable to years beginning after 2001. In response to comments received during the consultation process, revised draft legislation was released on August 2, 2001, still to be applicable to years beginning after 2001. Then, on December 17, 2001, Finance announced a one-year delay of the effective date of the proposals. The October 11, 2002 proposals are to be applicable to years that begin after 2002.
These proposals are designed to prevent taxpayers from deferring Canadian tax on income earned from interests in certain nonresident entities. Where the rules apply, the income from an investment in a FIE will be taxed under one of three regimes: the prescribed rate regime, the mark-to-market regime and the controlled foreign affiliate regime.
While these proposals are too complex to be reviewed in detail here, we will seek to provide a practical framework for determining when the FIE rules apply, where they apply and which of the three FIE regimes will be applicable.
The proposed FIE rules are applicable to a taxpayer who holds a participating interest in a nonresident entity that is a foreign investment entity where the participating interest is not an exempt interest of the taxpayer.
The first step in determining whether these proposed rules are applicable is to establish whether the taxpayer in question is an exempt taxpayer. Exempt taxpayers are generally individuals who have been resident in Canada for less than 60 months (to allow for immigration trusts) and persons who are otherwise exempt from Canadian income tax pursuant to subsection 149(1) of the Income Tax Act.
If the taxpayer is not an exempt taxpayer, it is necessary to determine whether he or she holds a participating interest in a nonresident entity. The definition of participating interest is very broad and includes shares in a corporation, certain interests in trusts and any other form of interest in a nonresident entity, as well as certain options or convertible or exchangeable property. But, a participating interest doesn't include an exempt interest.
An exempt interest includes an interest in: a FIE whose interests are widely held and actively traded on a prescribed foreign stock exchange of a country in which the FIE is resident; a FIE that is formed in and resident in a treaty country and its interests are widely held and actively traded; or a FIE that is formed in and resident in the US and the taxpayer is a resident of Canada and is a US citizen.
It is important to note that the above exceptions only apply where it is reasonable to determine that the taxpayer had no tax avoidance motive for the acquisition of the interest. Therefore, while these exceptions are designed to exclude certain foreign public company shares or mutual fund units that are traded on foreign stock exchanges, and interests in US real estate investment trusts and regulated investment companies from the FIE rules, such investments will not be excluded if there is a tax avoidance motive.
The definition of exempt interest also includes controlled foreign affiliates of the taxpayer, certain interests held by financial institutions and rights under employee stock option plans. There are other interests that are exempt and a thorough review of the definition is required to determine if the interest in question is exempt. It should be noted that a determination that an interest is an exempt one doesn't necessarily mean the proposed rules won't apply. In particular, if the return on the participating interest tracks the return earned on certain properties, the mark-to-market regime may apply. The tracking rules are briefly discussed below.
Perhaps the most difficult portion of the analysis is determining whether the nonresident entity is a FIE. The term FIE is defined in the negative — that is, a nonresident entity is a FIE unless it is a partnership; it is an exempt foreign trust; the carrying value of all its investment property is not greater than 50% of the carrying value of all its property; or its principal business is not an investment business.
Partnerships are not included in the definition as they are flow-through entities and the income will be caught at the partner level. The term "exempt foreign trust" is defined in the new nonresident trust proposals to effectively include certain nonprofit trusts. The third and fourth exceptions require further analysis.
In order to determine whether the third exception is applicable, it is necessary to define investment property and to determine how carrying value is to be computed. Investment property is broadly defined to include certain shares, interests in partnerships, trusts, or other types of entities, indebtedness, annuities, commodities, real estate, Canadian or foreign resource properties, derivatives, currency and options in respect of any of these properties. Certain exempt properties are carved out of the investment property definition and include property that is used or held principally in a business carried on by the nonresident entity and certain types of debt owing by other entities. Carrying value is generally the value for the purpose of the consolidated balance sheet, adjusted for minority interests, prepared in accordance with Canadian, or substantially similar, generally accepted accounting principles, unless an election is made to value all property of the entity at fair market value. Alternatively, an election permits the use of the entity's unconsolidated balance sheet, with a look-through rule for significant interests in other entities.
For the purpose of the fourth exception, investment business includes a business with the principal purpose of earning income or profits from property (this includes interest, dividends, rents and royalties), from the insurance or reinsurance of risks, from the factoring of trade accounts receivable and from the disposition of investment property. Exceptions from the investment business definition include certain foreign financial institutions, and entities whose principal purpose is to derive income from various activities including certain resource activities, the leasing or licensing of certain properties, the sale of real estate developed by the entity and the rental of real estate under certain conditions.
If the above analysis indicates that the FIE rules are applicable, the next step is to determine which of the three regimes to use in calculating the annual income inclusion. The new default regime introduced in the most recent proposals is the prescribed rate regime. This regime is very similar to the regime in place under the old section 94.1.
Under the prescribed rate regime, the taxpayer's annual income inclusion will be calculated by multiplying the designated cost of the FIE investment by the prescribed interest rate applicable to overpaid taxes (base rate plus 2%). The designated cost is the actual cost of the investment plus income inclusions after 2002 as a result of these rules. If the investment was acquired prior to 2003, its cost will include its accrued gain, but not any accrued loss, at the end of 2002.
Income inclusions under this regime are deemed to be income from property and will be added to the adjusted cost base of the investment. The disposition of the investment will trigger a capital gain or loss as regularly calculated under the Act. Note that a capital loss arising from the disposition can be used to offset capital gains only, it cannot be carried back to offset previous income inclusions in respect of the investment.
The mark-to-market regime generally will apply where taxpayers so elect, but will be compulsory in certain other circumstances. For a taxpayer to apply this regime, the participating interest must have a readily obtainable fair market value. This defined requirement is generally met where the entity's interests are widely held, actively traded and listed on a prescribed stock exchange, or are retractable or redeemable at a price that is determined by reference to the fair market value of the property of the FIE and is an arm's length price.
The mark-to-market regime will be compulsory where the taxpayer holds a tracking interest in a "tracking entity" or in certain foreign insurance policies. The tracking interest rules are too complex to be described in detail here, however, the intent of the rules is to prevent the circumvention of the FIE rules through the acquisition of an exempt interest or an interest in an entity that is not a FIE. The rules will generally apply to a participating interest in a nonresident entity that owns (or where consolidated statements are used or the look-through rule applies, a subsidiary owns) certain types of property where the interest provides an entitlement to receive payments that are determined primarily by reference to production from or use of the property, gains or profit from the disposition of the property, income, profit, revenue or cash flow from the property, or any other similar criteria. The rules may also apply where the tracked property is owned by a third party. The tracking interest rules may result in entities that would otherwise be exempt from the FIE rules, partnerships and controlled foreign affiliates, being subject to the rules.
Where the mark-to-market rules apply, the annual income inclusion will be calculated by adding the fair market value of the interest at year's end, the applicable deferral amount, and amounts received by the taxpayer during the year and subtracting the cost of the interest (if acquired during the year) or fair market value of the interest (if held at the beginning of the year). The deferral amount is the accrued gain or loss when the mark-to-market regime first applied. The purpose of the deferral amount is to defer the taxation of gains accrued up to the time the mark-to-market rules apply and, in the case of capital property, to tax the accrued gain at capital gains inclusion rates. For this latter reason, the deferral amount is reduced by 50% for capital property.
Income under the mark-to-market regime is deemed to be income from property, except in cases where substantially all of the change in the nonresident entity's value is attributable to realized or unrealized capital gains or losses of the entity, in which case the income or loss is deemed to be a capital gain or loss from the disposition of capital property.
The third regime is the controlled foreign affiliate regime under which a taxpayer may elect to treat a nonresident entity as a controlled foreign affiliate. There are several conditions that must be met in order to make this election including:
· the nonresident entity must be a foreign affiliate of the taxpayer;
· the taxpayer or a controlled foreign affiliate of the taxpayer must hold a participating interest in the nonresident entity;
· and the taxpayer must have a qualifying interest in the nonresident entity.
This election results in the existing foreign accrual property income rules applying to the nonresident entity and may eliminate the taxation of phantom income that would otherwise result from the application of the prescribed cost or mark-to-market regimes. The election must be made in the first taxation year of the taxpayer in which the nonresident entity is a foreign affiliate of the taxpayer and the election is irrevocable.
The FIE proposals are very complex and far-reaching. Taxpayers will need to analyse all of their investments in nonresident entities to determine whether the rules apply, and where they do apply, to determine which regime is applicable.
Loren D. Kroeker, CA, is with the International Tax Services Group with Ernst & Young LLP in Vancouver
Technical Editor: Michel Lanteigne, FCA,Managing Partner, Tax for Canada, Ernst & Young LLP | 
