Notice of Ways and Means Motion October 2018 – Cross-Border Surplus Stripping Using Partnerships and Trusts

Cross-Border Surplus Stripping Using Partnerships and Trusts

 

Budget 2018

The Income Tax Act contains a rule (section 212.1) that is intended to prevent a non-resident shareholder from entering into transactions to extract free of tax (or “strip”) a Canadian corporation’s surplus in excess of the PUC of its shares, or to artificially increase the PUC of such shares. When applicable, this rule can result in a deemed dividend to the non-resident or can suppress the PUC that would otherwise have been created as a result of the transactions.

This cross-border anti-surplus-stripping rule seeks to prevent non-residents from achieving these tax benefits through a transfer of the shares of one corporation resident in Canada (the “Canadian subject corporation”), to another such corporation (the “Canadian purchaser corporation”) with which the non-resident does not deal at arm’s length, in exchange for shares of the Canadian purchaser corporation or other forms of consideration.

Although this rule partly addresses the use of a partnership as an intermediary, it does not expressly address situations where a non-resident person disposes of an interest in a partnership that owns shares of a Canadian subject corporation. Some taxpayers have attempted to exploit this aspect of the rule by engaging in internal reorganizations that involve a transfer by a non-resident of shares of a Canadian subject corporation to a partnership in exchange for an interest in the partnership. The partnership interest is then transferred to a Canadian purchaser corporation. The Government also has concerns with variations of this partnership planning, and similar planning involving trusts, both in the context of this rule and a similar rule that applies to corporate immigration.

To ensure that the underlying purposes of the cross-border anti-surplus-stripping rule, and the corresponding corporate immigration rule, cannot be frustrated by transactions involving partnerships or trusts, Budget 2018 proposes to amend these provisions to add comprehensive “look-through” rules for such entities. These rules will allocate the assets, liabilities and transactions of a partnership or trust to its members or beneficiaries, as the case may be, based on the relative fair market value of their interests.

Legislative Updates 

Non-arm’s length sales of shares by non-residents

ITA 212.1(1)

Subsection 212.1(1) of the Act, together with the operative rule in subsection 212.1(1.1), is an anti-avoidance rule designed to prevent the removal of corporate surplus – which would otherwise be subject to withholding tax under Part XIII of the Act upon distribution to a non-resident shareholder – as a tax-free return of capital or as proceeds from the disposition of the corporation’s shares giving rise to a capital gain.

Subsection 212.1(1) sets out the conditions of application of subsection 212.1(1.1). In general terms, it provides that subsection 212.1(1.1) applies where shares of a Canadian corporation (the “subject corporation”) held by a non-resident person or a designated partnership are transferred to another Canadian corporation (the “purchaser corporation”) with which the transferor does not deal at arm’s length and, immediately after the disposition, the subject corporation is connected (within the meaning that would be assigned by subsection 186(4), with certain modifications) with the purchaser corporation.

Subsection 212.1(1) is amended, in connection with the introduction of “look-through” rules for partnerships and trusts in new subsections 212.1(5) to (7), to delete the reference to the term “designated partnership” (the definition of “designated partnership” in paragraph 212.1(3)(e) is also being deleted consequential on this amendment). This amendment, in combination with the new look-through rules, effectively extends the application of section 212.1 to dispositions of subject shares by partnerships that are not designated partnerships (as defined under existing paragraph 212.1(3)(e)) but that have one or more non-resident members, in circumstances where the other conditions in subsection 212.1(1) are met.

For example, if a partnership with only one non-resident member (that has a minority interest in the partnership) disposes of subject shares to a purchaser corporation, for the purposes of subsections 212.1(1) and (1.1), new paragraph 212.1(6)(b) will deem the non-resident member (as well as any other members) to dispose of the subject shares to the purchaser in proportion to the relative fair market value of its partnership interest. Notably, however, in order for subsection 212.1(1.1) to apply to such a disposition, the non-resident member must not deal at arm’s length with the purchaser corporation (including based on the expanded meaning of non-arm’s length under paragraph 212.1(3)(a)).

Consequential on the deletion of the “designated partnership” reference, the defined term “non-resident person” is also deleted, as subsection 212.1(1) will apply only in respect of a non-resident person.

Subsection 212.1(1) is further amended, consequential on the introduction of the “look-through” rule in new subsection 212.1(6), to provide that, for the purpose of determining whether a subject corporation is connected with a purchaser corporation, subsection 186(4) is to be read without reference to subsection 186(6). This amendment ensures that the look-through rule in paragraph 212.1(6)(d) is used instead of the rules in subsection 186(6) for this purpose.

Non-arm’s length sales of shares by non-residents

ITA 212.1(1.1)(a)

Subsection 212.1(1.1) of the Act sets out the operative rule that applies if the conditions in subsection 212.1(1) are satisfied.

Consequential on the amendment to subsection 212.1(1) eliminating the defined term “non-resident person”, paragraph 212.1(1)(a) is amended to clarify that the reference in that paragraph to “the non-resident person” is to the non-resident person referred to in subsection 212.1(1), who disposes of (or is deemed to dispose of) the subject shares to the purchaser corporation.

Deemed consideration

ITA 212.1(1.2)

Subsection 212.1(1.2) of the Act provides a deemed consideration rule for the purposes of subsections 212.1(1) and (1.1), clarifying the application of those rules in situations where it may otherwise be uncertain whether consideration has been received by a non-resident person from a purchaser corporation in respect of the disposition by the non-resident person of subject shares.

Consequential on the amendment to subsection 212.1(1), which eliminates the defined term “non-resident person”, subsection 212.1(1.2) is amended to ensure that its reference to the “non-resident person” is to the non-resident person referred to in subsection 212.1(1), who disposes of (or is deemed to dispose of) the subject shares to the purchaser corporation.

Relationship rules

ITA 212.1(3)

Subsection 212.1(3) of the Act sets out certain interpretive rules for the purpose of applying section 212.1.

Paragraph 212.1(3)(a) deems certain persons to not deal at arm’s length for the purpose of applying section 212.1. Paragraph 212.1(3)(b) provides rules that, for the purposes of paragraph 212.1(3)(a), deem a non-resident person to own shares that are owned by certain other (generally, related) persons or partnerships.

Paragraphs 212.1(3)(a) and (b) are amended, consequential on the amendments to subsection 212.1(1), to remove the references to the term “designated partnership”, as this is no longer a relevant concept or defined term for the purposes of section 212.1. The defined term “taxpayer” is also eliminated in paragraph 212.1(3)(b), consequential on the removal of the “designated partnership” references.

Paragraph 212.1(3)(e) defines “designated partnership” as a partnership in respect of which a majority interest partner or every member of a majority interest group of partners is a non-resident person. Paragraph 212.1(3)(e) is repealed, consequential on the deletion of the reference to “designated partnership” in subsection 212.1(1).

Subsection 212.1(3) is also amended to generally update its structure in accordance with current legislative drafting standards.

For more information, see the commentary on subsection 212.1(1).

Where section does not apply

ITA 212.1(4)(b)

Subsection 212.1(4) of the Act provides a relieving exception to the rules in section 212.1 that applies in respect of a disposition by a non-resident corporation of shares of a subject corporation to a purchaser corporation that, immediately before the disposition, controlled the non-resident corporation.

Subparagraph 212.1(4)(b)(i) is amended by replacing the word “owns” with the word “held” for consistency within section 212.1.

Tiered trusts and partnerships

ITA 212.1(5)

New subsection 212.1(5) of the Act is a “look-through” rule for tiered trusts and partnerships (i.e., trusts or partnerships that are themselves beneficiaries under trusts or members of partnerships). It is intended to apply to a tiered structure that includes any combination of trusts and partnerships in any number of tiers.

Paragraph 212.1(5)(a) looks through tiers of partnerships and trusts for the purpose of determining whether a person or partnership is a beneficiary of a lower-tier trust or a member of a lower-tier partnership. It ensures that

  • a beneficiary of a trust that is itself a beneficiary of another trust will be deemed to be a beneficiary of the other trust;
  • a beneficiary of a trust that is a member of a partnership will be deemed to be a member of the partnership;
  • a member of a partnership that is a beneficiary of a trust will be deemed to be a beneficiary of the trust; and
  • a member of a partnership that is a member of another partnership will be deemed to be a member of the other partnership.

Paragraph 212.1(5)(b) looks through tiers of partnerships and trusts for the purpose of determining the interest the beneficiary of the upper-tier trust or member of the upper-tier partnership is considered to have in the lower-tier trust or partnership. In effect, it deems the upper-tier beneficiary or member to hold a direct interest in the lower-tier trust or partnership that is equivalent to the interest it actually holds indirectly through tiers.

Subsection 212.1(5) does not, however, deem the actual beneficiaries or members of the lower-tier trust or partnership not to be the beneficiaries or members of, and not to hold a direct interest in, respectively, the lower-tier trust or partnership.

The one exception to the look-through rules for trusts and partnerships in subsection 212.1(5) is that those rules will not look through a trust that is the non-resident person referred to in subsection 212.1(1) (i.e., the non-resident that disposes of the subject shares to the purchaser corporation, determined having regard to the subsection 212.1(6) and (7)). Since a disposition by such a trust is within the scope of subsection 212.1(1) (i.e., because it is a non-resident person), looking through such a trust would lead to inappropriate results under section 212.1 in certain circumstances.

While new subsection 212.1(5) applies for the purposes of section 212.1 as a whole, it is most relevant for the application of the ownership attribution rules in paragraphs 212.1(3)(b) and (c), and the look-through rules for trusts and partnerships in new subsections 212.1(6) and (7). Where a disposition or acquisition of subject shares is mediated by a tiered structure, it is intended that subsection 212.1(5) apply first, for the purposes of determining the identities and relative interests of trust beneficiaries or partnership members, and then subsection 212.1(6) be applied based on such determinations.

Trusts and partnerships look-through rule

ITA 212.1(6)

New subsection 212.1(6) of the Act contains “look-through” rules for trusts and partnerships. These rules are intended to ensure that subsections 212.1(1) and (1.1) apply appropriately – and taxpayers cannot avoid, or obtain a more favourable result under, subsection 212.1(1.1) – where shares of a Canadian-resident corporation are held, disposed of or acquired through or by one or more trusts or partnerships.

Subsection 212.1(6) is, in general terms, organized as follows:

  • where a trust or partnership holds shares of a corporation resident in Canada, paragraph (a) treats a disposition or acquisition of an interest in the trust or partnership as a disposition or acquisition of the shares by its beneficiaries or members;
  • paragraph (b) treats a disposition of shares of a corporation resident in Canada by a trust (other than a non-resident trust) or a partnership as a disposition of the shares by its beneficiaries or members;
  • where a partnership or trust acquires shares of a corporation resident in Canada, paragraph (c) treats the acquisition as an acquisition of the shares by its members or beneficiaries; and
  • paragraph (d) looks through trusts and partnerships to attribute ownership of shares of a corporation resident in Canada to their beneficiaries or members.

Paragraph 212.1(6)(a) applies if a beneficiary or a member (referred to as a “holder) of a trust or partnership (referred to as a “conduit”) disposes of an interest in the conduit (referred to as the “pertinent interest”) and any portion of the fair market value of the interest is attributable to shares of a corporation resident in Canada held, directly or, under certain circumstances (discussed below), indirectly, by the conduit (referred to as the “shares held by the conduit”). If paragraph 212.1(6)(a) applies, then the holder is deemed to have:

  • disposed of, and the purchaser is deemed to have acquired, the shares held by the conduit in the proportion that the portion of the fair market value of the pertinent interest that is attributable to the shares held by the conduit is of the total fair market value of the shares held by the conduit; and
  • received from the purchaser (and the purchaser is deemed to have paid to the holder) consideration for the shares that are deemed to have been disposed of by the holder. This deemed consideration is equal to the proportion of the fair market value of the consideration actually received by the holder from the purchaser for the pertinent interest that the portion of the fair market value of the pertinent interest that is attributable to the shares held by the conduit is of the total fair market value of the pertinent interest.

Paragraph 212.1(6)(a) applies not only for the purposes of subsections 212.1(1) and (1.1), but also for the purposes of subsection 212.1(6) itself. The latter is necessary to ensure that the look-through rules operate appropriately in cases where, for example, the pertinent interest is disposed of by a holder that is itself a conduit, in which case the application of paragraph 212.1(6)(a) will, in turn, engage paragraph 212.1(6)(b).

In determining whether any portion of the fair market value of the pertinent interest is attributable to the shares held by the conduit (a condition for the application of paragraph 212.1(6)(a)), any shares of a corporation resident in Canada that are held directly or indirectly by the conduit are to be taken into consideration, unless all of the shares of the corporation that are held directly or indirectly by the conduit are held indirectly through one or more non-resident corporations. The latter exception is intended to ensure that paragraph 212.1(6)(a) does not apply in circumstances where surplus-stripping opportunities are not available.

It is intended that, under paragraph 212.1(6)(a), each holder or purchaser is deemed to dispose of or acquire, as the case may be, a proportionate number of the shares held by the conduit, rather than a proportion of each such share. In this respect, the deeming rules in paragraphs 212.1(6)(b) and (c) are intended to apply with similar effect to paragraph (a).

The dispositions are deemed to occur on a class-by-class basis. And so, if a conduit holds multiple classes of shares, the formula is applied so that the holder is deemed to dispose of a portion of each such class.

The references to “interests” in subsection 212.1(6) are to interests as a beneficiary under a trust or as a member of a partnership. In addition, in the case of a structure involving tiers of trusts or partnerships (or both), the identities and interests of the beneficiaries of a trust or members of a partnership for the purposes of subsection 212.1(6) are to be determined under subsection 212.1(5). For more information, see the commentary on subsection 212.1(5).

Paragraph 212.1(6)(b) provides that if a conduit (other than a non-resident trust) disposes of shares of a corporation resident in Canada to a purchaser, then each holder of an interest in the conduit is deemed to have:

  • disposed of the shares to the purchaser in the proportion that the fair market value of the holder’s interest in the conduit is of the total fair market value of all interests in the conduit; and
  • received from the purchaser (and the purchaser is deemed to have paid to each holder) consideration for the shares that are deemed to have been disposed of by the holder.

This deemed consideration is equal to the proportion of the fair market value of the consideration actually received by the conduit from the purchaser for the shares that the fair market value of the holder’s interest in the conduit is of the total fair market value of all interests in the conduit.

Paragraph 212.1(6)(b) applies for the purposes of paragraph 212.1(6)(c) in order to ensure that the look-through rules operate appropriately in cases where, for example, a conduit disposes of shares of a corporation resident in Canada to another conduit, in which case paragraph 212.1(6)(b) will apply to determine the identity of the vendor for purposes of paragraph 212.1(6)(c).

Paragraph 212.1(6)(b) applies to dispositions by any conduit, except for non-resident trusts. The latter exception is because subsections 212.1(1) and (1.1) already apply in respect of dispositions of shares of Canadian-resident corporations by non-resident trusts; looking through disposing non-resident trusts would therefore provide inappropriate results in certain cases.

Paragraph 212.1(6)(b) amends the scheme under section 212.1 that applies to dispositions of shares of Canadian-resident corporations by partnerships. Under existing subsection 212.1(1), subsection 212.1(1.1) applies only in respect of dispositions by designated partnerships (as defined in paragraph 212.1(3)(e)). By contrast, the new look-through rule in paragraph 212.1(6)(b), in combination with the elimination of the “designated partnership” concept in section 212.1, extends the application of subsection 212.1(1.1) to dispositions by partnerships that are not (under the current rules) designated partnerships but that have one or more non-resident members, in circumstances where the other conditions in subsection 212.1(1) are met. For more information, see the commentary on subsection 212.1(1).

Paragraph 212.1(6)(c) provides that if a conduit acquires shares of a corporation resident in Canada from a vendor, then each holder of an interest in the conduit is deemed to have:

  • acquired the shares from the vendor in the proportion that the fair market value of the holder’s interest in the conduit is of the total fair market value of all interests in the conduit; and
  • paid to the vendor (and the vendor is deemed to have received from each such holder) consideration for the shares that are deemed to have been acquired by the holder. This deemed consideration is equal to the proportion of the fair market value of the consideration actually paid by the conduit to the vendor for the shares that the fair market value of the holder’s interest in the conduit is of the total fair market value of all interests in the conduit.
Example 1 – Interaction between paragraphs 212.1(6)(a) and (b)

Assumptions

  1. NR, a non-resident corporation, is a member of a partnership (P1) which in turn is a member of another partnership (P2).
  2. P2 owns 80% of the shares of Canco1, a corporation resident in Canada.
  3. P2 also owns all of the shares of USCo, a corporation resident in the United States, which in turn owns the remaining 20% of the shares of Canco1.
  4. NR also owns all of the shares of Canco2, a corporation resident in Canada.
  5. At a particular time, P1 disposes of its interest in P2 to Canco2 for non-share consideration.
  6. Immediately after the particular time, Canco1 is connected with Canco2 for the purposes of subsection 212.1(1).

Analysis

Pursuant to paragraph 212.1(6)(a), at the particular time, P1 (i.e., the “holder” of the “pertinent interest”) is deemed to have disposed of, to the purchaser (i.e., Canco2), the shares of Canco1 held indirectly through P2 (i.e., the “shares held by the conduit”) in the proportion determined under subparagraph 212.1(6)(a)(i) and to have received, from Canco2, as consideration for those shares, the amount determined under subparagraph 212.1(6)(a)(ii).

For the purposes of determining, under paragraph 212.1(6)(a), the portion of the fair market value of the pertinent interest that is attributable to the shares of Canco1 held by P2, all the shares of Canco1 that are held indirectly by P1 through P2, including those held indirectly through USCo, are taken into consideration. If USCo instead owned all of the issued and outstanding Canco1 shares directly, such that all of the shares of Canco1 were held by P1 indirectly through USCo, then the conditions in paragraph 212.1(6)(a) would not be satisfied based solely on the above assumptions.

Because the deeming rules in paragraph 212.1(6)(a) apply for the purposes of subsection 212.1(6), paragraph 212.1(6)(b) deems NR to have, at the particular time, disposed of, to Canco2, the shares of Canco1 that are deemed by paragraph 212.1(6)(a) to have been disposed of by P1, in the proportion determined under subparagraph 212.1(6)(b)(i), and received, from Canco2, as consideration for those shares, the amount determined under subparagraph 212.1(6)(b)(ii).

As a result, paragraph 212.1(1.1)(a) deems Canco2 to pay a dividend to NR, to the extent the fair market value of the consideration that NR is deemed by subparagraph 212.1(6)(b)(ii) to have received from Canco2 for the shares of Canco1 exceeds the paid-up capital in respect of those Canco1 shares immediately before the disposition.

Pursuant to paragraph (k) of the definition proceeds of disposition in section 54, any dividend deemed to be paid to NR under subsection 212.1(1.1) is excluded in determining the proceeds of disposition of the interest in P2 disposed of by P1.

Example 2 – Interaction between paragraphs 212.1(6)(b) and (c)

Assumptions

Same as Example 1, except that:

  • Canco2 is a member of a partnership (P3); and
  • Instead of P1 disposing of its interest in P2 directly to Canco2 at the particular time, P1 disposes of its interest in P2 to P3.

Analysis

Same as under Example 1, except that:

  • Paragraph 212.1(6)(b) deems NR to have, at the particular time, disposed of the Canco1 shares to P3 – and received the consideration for those shares from P3 – instead of Canco2;
  • Because the deeming rules in paragraph 212.1(6)(b) apply for the purposes of paragraph 212.1(6)(c), paragraph 212.1(6)(c) deems Canco2, at the particular time, to have
    • acquired from NR (i.e., the “vendor”, as determined under paragraph 212.1(6)(b)) the shares of Canco1 acquired by P3, in the proportion determined under subparagraph 212.1(6)(c)(i), and
    • paid to NR, as consideration for those shares, the amount determined under subparagraph 212.1(6)(c)(ii); and
  • The dividend Canco2 is deemed to pay to NR pursuant to paragraph 212.1(1.1)(a) is based on the consideration that NR is deemed by subparagraph 212.1(6)(c)(ii) to have received from Canco2 for the shares of Canco1.

Paragraph 212.1(6)(d) provides that if shares of a corporation resident in Canada are owned by a conduit, each holder of an interest in the conduit is deemed to own the shares in proportion to its interest in the conduit. Specifically, the holder is deemed to own the proportion of the number of shares of each class that are owned by the conduit that the fair market value of the holder’s interest in the conduit is of the fair market value of all interests in the conduit.

Paragraph 212.1(6)(d) applies for the purpose of determining whether a subject corporation is connected with a purchaser corporation (within the meaning of 186(4), with certain modifications), as required under subsection 212.1(1), where the shares of the subject corporation are held by the purchaser corporation through one or more conduits. It is intended that, by deeming the holders to own, proportionately, the actual shares owned by the conduit, the holders will be considered to hold any rights attaching to those shares (e.g., the voting rights attached to the shares).

The deemed consideration rules in subparagraphs 212.1(6)(a)(ii), (b)(ii) and (c)(ii) do not apply in cases where shares of the purchaser corporation are issued as consideration for the subject shares. Rather, in such circumstances, paragraph 212.1(1.1)(b) applies to determine the amount of any paid-up capital reduction in respect of the shares of the purchaser corporation, without the need for a special deemed-consideration rule. Any use of one or more trusts or partnerships (e.g., with one or more Canadian-resident beneficiaries or members) in order to increase the paid-up capital of shares through the interaction of the new look-through rules in subsection 212.1(6) with the rule in paragraph 212.1(1)(b) that provides for a reduction of paid-up capital, would be contrary to the policy underlying subsection 212.1(6) and, more generally, section 212.1.

Avoidance of subsections (5) and (6)

ITA 212.1(7)

New subsection 212.1(7) of the Act is an anti-avoidance rule predicated on the general policy against the use of discretionary or similar interests to avoid certain tax consequences. More particularly, subsection 212.1(7) is intended to prevent taxpayers from using discretionary interests in trusts with a view to circumventing the application of the look-through rules in new subsection 212.1(5) or (6) (e.g., by taking the position that the fair market value of an interest as a beneficiary under a trust is nil or nominal because it is a discretionary interest in the trust).

Subsection 212.1(7) applies if

  • the share, of a beneficiary under a trust, of the accumulating income or capital of the trust depends on the exercise by any person of, or the failure by any person to exercise, any discretionary power; and
  • it can reasonably be considered that one of the reasons the discretionary power is conferred on the person is to avoid or limit the application of subsection 212.1(1.1).

The foregoing conditions of application reflect a concern that taxpayers may, in the absence of subsection 212.1(7), take discretionary interests in trusts in an attempt to mitigate or avoid certain results under the look-through rules that are based on the relative fair market value of an interest in a trust. To prevent this, new subsection 212.1(7) effectively deems a beneficiary under a trust to hold or acquire, as the case may be, all of the property held or acquired by the trust in certain circumstances. This result is achieved by effectively deeming the beneficiary to have a 100% interest in the trust for the purposes of paragraphs 212.1(5)(b) and (6)(d) and subparagraph (6)(c)(i).

Coming-into-force

The above amendments to section 212.1 apply in respect of dispositions that occur after February 26, 2018.

Source: 

Budget 2018

Notice of Ways and Means Motion  February 27, 2018 

Explanatory Notes Relating to the Income Tax Act and to Other Legislation

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