Notice of Ways and Means Motion October 2018: Foreign Affiliates

Foreign Affiliates

 

Budget 2018

Budget 2018 proposes modifications to the foreign affiliate rules as a result of the Government’s ongoing monitoring of developments in this area.

A foreign affiliate of a taxpayer resident in Canada is a non-resident corporation in which the taxpayer has a significant interest. A controlled foreign affiliate of a taxpayer is generally a foreign affiliate in which the taxpayer has, or participates in, a controlling interest.

The taxpayer’s share of the income of a foreign affiliate from an active business is not taxed until such time as it is paid as a dividend by the affiliate to the taxpayer. This dividend can be received tax-free to the extent that it is paid out of the foreign affiliate’s exempt surplus. A foreign affiliate will have exempt surplus if it has income from an active business carried on by it in a country with which Canada has a tax treaty or a tax information exchange agreement (TIEA) and it is resident in such a country.

Certain income of a controlled foreign affiliate (i.e., income from property, from a business other than active business and from other specified sources) is taxable in the hands of the taxpayer in the year in which it is earned, whether or not it is distributed, with an offsetting deduction for taxes paid by the affiliate. This income is referred to as foreign accrual property income (FAPI).

Investment Business, the “Six Employees Test”, and Tracking Arrangements

Income from an investment business carried on by a foreign affiliate of a taxpayer is included in the foreign affiliate’s FAPI. An investment business is generally defined as a business the principal purpose of which is to derive income from property. However, an investment business does not include a business carried on by a foreign affiliate if certain conditions are satisfied. One of these conditions, in general terms, is that the affiliate employ more than five full-time employees (or the equivalent) in the active conduct of the business. This condition is sometimes referred to as the “six employees test”. If the affiliate’s investment activities are so significant that they require more than five full-time employees and the other conditions are satisfied, the affiliate’s business is treated as an active business and income from that business is excluded from FAPI.

The investment business definition applies on a business-by-business basis. Accordingly, to the extent that a single foreign affiliate carries on multiple businesses, each such business would have to meet the six employees test in order to ensure that it is not an investment business.

Certain taxpayers whose foreign investment activities would not warrant more than five full-time employees have engaged in tax planning with other taxpayers in similar circumstances seeking to meet the six employees test. This planning involves grouping their financial assets together in a common foreign affiliate in order to carry on investment activities outside of Canada through that affiliate. While the taxpayers combine their assets in a common affiliate and take the position that the affiliate is carrying on a single business, their respective returns are determined separately by reference to their contributed assets.

To effect this planning, the share, contractual or other rights under these arrangements typically ensure that each taxpayer retains control over its contributed assets and that any returns from those assets accrue to its benefit. This type of planning is sometimes referred to as a “tracking arrangement”. In such arrangements, the assets contributed by the (often unrelated) Canadian taxpayers are not truly pooled, as the economic outcome for each taxpayer remains unchanged. The affiliate is essentially used as a conduit entity to shift passive investment income offshore and later repatriate that income to Canada tax-free.

It is not intended that taxpayers be permitted to satisfy the six employees test in these circumstances.

To ensure the rules operate as intended, Budget 2018 proposes to introduce a rule for the purposes of the investment business definition so that, where income attributable to specific activities carried out by a foreign affiliate accrues to the benefit of a specific taxpayer under a tracking arrangement, those activities carried out to earn such income will be deemed to be a separate business carried on by the affiliate. Each separate business of the affiliate will therefore need to satisfy each relevant condition in the investment business definition, including the six employees test, in order for the affiliate’s income from that business to be excluded from FAPI.

This measure will apply to taxation years of a taxpayer’s foreign affiliate that begin on or after Budget Day.

Whether one or more separate businesses is carried on is a question of fact that must be determined on the basis of all relevant facts and surrounding circumstances. The introduction of this deeming rule for the purposes of the investment business definition ensures that a foreign affiliate will be treated as having separate businesses where a tracking arrangement exists. Some tracking arrangements may give rise to separate businesses irrespective of whether this new rule applies. The Canada Revenue Agency (CRA) may challenge such arrangements (and other planning with similar effect) on this basis and may also seek to apply existing anti-avoidance rules where appropriate.

Tracking Arrangements to Avoid Controlled Foreign Affiliate Status

The FAPI of a foreign affiliate of a taxpayer is included in the taxpayer’s income on an accrual basis only where the affiliate is a controlled foreign affiliate of the taxpayer. To avoid such accrual taxation, certain groups of Canadian taxpayers have used tracking arrangements to avoid controlled foreign affiliate status (i.e., the group of taxpayers is sufficiently large that they take the position that they do not have, and do not participate in, a controlling interest in the affiliate). Under the tracking arrangement, each taxpayer retains control over its contributed assets and any returns from those assets accrue to its benefit. This is sometimes effected through the establishment of separate cells or segregated accounts that track those contributed assets and respective returns. It is not intended that taxpayers avoid controlled foreign affiliate status, and therefore accrual taxation of FAPI, in these circumstances.

To address this concern, Budget 2018 proposes to deem a foreign affiliate of a taxpayer to be a controlled foreign affiliate of the taxpayer if FAPI attributable to activities of the foreign affiliate accrues to the benefit of the taxpayer under a tracking arrangement. This measure is intended to ensure that each taxpayer involved in such a tracking arrangement – no matter how large the group – is subject to accrual taxation in respect of FAPI attributable to that taxpayer.

This measure will apply to taxation years of a taxpayer’s foreign affiliate that begin on or after Budget Day.

This new rule is aimed at providing greater assurance that taxpayers cannot avoid accrual taxation of FAPI using a tracking arrangement. The CRA will continue, in appropriate circumstances, to challenge such arrangements (and other arrangements with similar effect), including through the use of existing anti-avoidance rules.

Reassessments

After a taxpayer files an income tax return for a taxation year, the CRA is required to perform an initial assessment of tax payable with all due dispatch. For most taxpayers with foreign affiliates, the CRA generally has four years after its initial assessment (referred to as the “normal reassessment period”) in which to audit and reassess the taxpayer’s tax liability and is generally barred from reassessing beyond that period.

Audits in respect of foreign affiliates are generally time-consuming; they often involve issuing requirements for information located in foreign jurisdictions and requesting the exchange of information from a tax treaty or TIEA partner. In such circumstances, it can be challenging for the CRA to obtain information required for the purposes of auditing and reassessing a taxpayer’s tax liability within the normal reassessment period.

A three-year extended reassessment period currently exists in respect of assessments made as a consequence of a transaction involving a taxpayer and a non-resident with whom the taxpayer does not deal at arm’s length. (This provision is also discussed under “Reassessment Period – Non-Resident Non-Arm’s Length Persons”.) Although this three-year extension currently applies to many transactions involving foreign affiliates, it does not apply in all relevant circumstances.

Given the complexity of audits that involve foreign affiliates and in order to ensure that the CRA has an opportunity to properly examine all activities in respect of foreign affiliates that are relevant to the Canadian tax base, Budget 2018 proposes to extend the reassessment period for a taxpayer by three years in respect of income arising in connection with a foreign affiliate of the taxpayer.

This measure will apply to taxation years of a taxpayer that begin on or after Budget Day.

 

Legislative Updates 

Tracking interests – overview

ITA 95(8) to (12)

New subsections 95(8) to (12) of the Act address certain tax consequences under the foreign affiliate rules in the Act in relation to structures that use so-called “tracking arrangements” in respect of foreign affiliates of taxpayers. Tracking arrangements often involve the grouping of assets and activities of multiple shareholders in a common corporation in order to achieve certain tax benefits. In such arrangements, the assets contributed by the shareholders are not truly pooled or integrated within the corporation as the economic outcome for each shareholder in respect of their contributed assets is comparable to the outcome that would arise if the assets continued to be held by the shareholder directly or were contributed by each shareholder into separate, wholly-owned corporations. This “tracking” is often effected either through rights attaching to the shares of the common corporation (e.g., through separate share classes) or more indirect interests (e.g., contractual arrangements) with a similar effect.

Two specific measures are introduced to ensure appropriate income tax consequences in cases where there is a tracking arrangement in respect of a foreign affiliate of a taxpayer. The first (the operative rule is in subsection 95(9)) deals with the avoidance of the “investment business” rules contained in subsection 95(1) – a significant component of the “foreign accrual property income” (FAPI) regime applicable to foreign affiliates of Canadian taxpayers. The second, in subsections 95(10) to (12), deals with the avoidance of accrual-based taxation of FAPI through the avoidance of “controlled foreign affiliate” (“CFA”) status. These new rules are intended to provide greater certainty that taxpayers cannot avoid the FAPI regime within the foreign affiliate rules in the Act through the use of tracking arrangements.

Tracking interests – interpretation

ITA 95(8)

New subsection 95(8) of the Act is an interpretation rule applicable for the new rules dealing with tracking arrangements. It generally provides that, for the purposes of new subsections 95(9) to (12), a property constitutes a tracking interest in a person or partnership (referred to as the “tracked entity”) if

  • all or part of the fair market value of the property, or of any payment or right to receive an amount in respect of the property, can reasonably be considered to be determined, directly or indirectly, by reference to certain criteria (enumerated in subparagraphs 95(8)(a)(i) to (iv)) in respect of property and activities (referred to as the “tracked property and activities”) of the person or partnership; and
  • the tracked property and activities do not represent all of the property and activities of the person or partnership.

For example, a tracking interest will generally exist if a corporation’s assets and activities are not fully pooled together for the benefit of all of its shareholders, such that one or more shareholders holds shares of a class that derive their value from only some, and not all, of the corporation’s property and activities. The reference in paragraph 95(8)(a) to “any payment or right to receive an amount” is intended to capture cases where the value of the payment or right to receive the amount is not clearly reflected in the fair market value of the taxpayer’s rights (referred to in the legislation as the “particular property”) in respect of the corporation. For example, this could include a discretionary interest in respect of the corporation.

The reference in paragraph 95(8)(a) to the fair market value of the particular property being determined “directly or indirectly” by reference to the enumerated criteria is intended to capture not only circumstances where the tracking is embedded in the terms of shares issued by the tracked entity, but also where the tracking is more indirect, such as through a chain of entities that includes the tracked entity or through contractual rights.

In determining whether a property or activity of a tracked entity is part of the tracked property and activities, what is relevant is not whether the value of the property or activity (or another criterion described in subparagraphs 95(8)(a)(i) to (iv) in respect of the property or activity) actually contributes to the fair market value of the tracking interest, but rather whether in principle it would so contribute if the particular property or activity had value. Thus, where, for example, the value of a property or activity does not contribute to the fair market value of shares of the tracked entity owned by a taxpayer because the property or activity is of nil or indeterminate value, this would not in and of itself exclude the property or activity from being part of the tracked property and activities (i.e., it would not necessarily lead to the conclusion that the tracked property and activities do not represent all of the tracked entity’s property and activities such that the condition in paragraph 95(8)(b) is met).

Tracking interests – investment business definition

ITA 95(9)

Subsection 95(9) of the Act is one of the main operative rules introduced to address tracking arrangements in the context of foreign affiliates of Canadian taxpayers. It applies for the purpose of the “investment business” definition in subsection 95(1) to deem certain properties and activities that may otherwise be considered to be part of one business to instead constitute two or more separate businesses.

Subsection 95(9) applies, in respect of a foreign affiliate of a taxpayer for a taxation year of the affiliate, if, at any time in the year, a person or partnership holds a tracking interest (within the meaning of subsection 95(8)) in respect of the affiliate or a partnership of which the affiliate is a member. Where applicable, subsection 95(9) deems the tracked properties and activities in respect of each such tracking interest – to the extent they would not otherwise be part of an investment business – to be a separate business carried on by the affiliate throughout the year (and not to be part of any other business of the affiliate). These separate businesses are deemed in respect of every taxpayer of which the tracked entity is a foreign affiliate.

As the investment business rules apply on a business-by-business basis, the intention is that the deeming of a separate business under subsection 95(9) will require, among other things, each separate business to satisfy the “more than five employees” condition in paragraph (c) of the “investment business” definition on its own in order to be excepted from the investment business rules.

In determining whether a deemed separate business meets the conditions for an exception from the “investment business” definition, the characteristics and components of the actual business are to be to attributed to the separate business on a reasonable basis (e.g., the necessary employees for the property and activities forming the separate business are to be allocated to the separate business). If the separate business is determined to be an investment business, then income attributable to the tracked property and activities (i.e., the property and activities of the separate business) is to be treated as income from an investment business, which is included in the “income from property” (as defined in subsection 95(1)) of a foreign affiliate of a taxpayer.

In many circumstances, business activities that track separately to different tracking interests in a corporation would be expected to constitute separate businesses under general principles, even absent subsection 95(9); this new rule is intended to ensure this result in all cases involving tracking interests.

Tracking class – separate corporation

ITA 95(10) and (11)

New subsections 95(10) and (11) of the Act, together with new subsection 95(12), are intended to prevent the avoidance of CFA status – and therefore accrual-based taxation of FAPI – through the use of tracking arrangements. Subsections 95(10) and (11) address tracking arrangements where the tracking is embedded in shares of a foreign affiliate, and subsection 95(12) applies in respect of all other tracking arrangements involving foreign affiliates.

Tracking arrangements often involve the grouping of assets and activities of multiple shareholders in a common corporation in order to achieve certain tax benefits, but with the economic outcome – and often the degree of control – for each shareholder in respect of their contributed assets and activities being comparable to a situation where the assets and activities had been contributed by each shareholder in separate, wholly-owned corporations. Where the corporation is a foreign affiliate of the shareholder, it is generally appropriate that the affiliate be treated as a CFA in these circumstances.

In general terms, where applicable, the operative rule in subsection 95(11) deems the property and activities of a foreign affiliate of a taxpayer that are tracked under the taxpayer’s tracking interest to be those of a separate, notional corporation – and any shareholders that own shares of the affiliate that track the tracked property and activities to own voting shares of the separate corporation – for certain purposes. This serves two main purposes. First, it ensures that CFA status is determined in relation to the tracked property and activities, rather than the affiliate as a whole. Generally, under these rules, CFA status will arise where the tracked portion of the affiliate would, if it had been a separate corporation, be a CFA of the taxpayer; conversely, CFA status generally will not arise if such a separate corporation would not be a CFA of the taxpayer. Second, where the application of the deemed separate corporation rules results in CFA status, the rules are intended to also ensure appropriate FAPI attribution, by requiring that the taxpayer determine its FAPI income inclusion under subsection 91(1) based on its proportionate entitlement to the income from the tracked property and activities.

Subsection 95(10) provides the conditions for the application of the operative rule in subsection 95(11). In general terms, subsection 95(11) applies in respect of a foreign affiliate of a taxpayer for a taxation year of the affiliate if, at any time in the year,

  • the taxpayer holds a tracking interest in respect of the affiliate; and
  • shares of a class (referred to as the “tracking class”) of the affiliate, the fair market value of which can reasonably be considered to be determined by reference to the tracked property and activities in respect of the taxpayer’s tracking interest, are held by the taxpayer or a foreign affiliate of the taxpayer.

While the concept of a “tracking interest” – and thus the scope of application of the residual rule in subsection 95(12) that is based on that concept – is broad, the deemed separate corporation fiction under subsection 95(11) applies in more limited circumstances, namely where the tracking arrangement is effected through a tracking class. However, in order for subsection 95(11) to apply, the taxpayer does not need to own shares of a tracking class; rather, the taxpayer can own shares of an upper-tier foreign affiliate that do not track particular property or activities of the upper-tier affiliate but that nonetheless constitute a tracking interest (within the meaning of subsection 95(8), which includes indirect interests) in respect of a lower-tier foreign affiliate, where the upper-tier affiliate owns shares of a tracking class of the lower-tier affiliate.

Where applicable, subsection 95(11)

  • deems the existence of a corporation (referred to as the “separate corporation”) that is separate from the actual corporation (referred to as the “actual affiliate”) that has issued the shares of the tracking class (paragraph 95(11)(a));
  • attributes to that separate corporation the tracked property and activities, any associated rights and obligations, and any income, losses or gains in respect of the tracked property and activities (paragraphs 95(11)(a) to (c)); and
  • provides for the share structure of the deemed separate corporation, for the purpose of determining CFA status and attributing the appropriate amount of FAPI to the taxpayer under subsection 91(1), by
    • deeming the separate corporation to have a single class of shares, comprising 100 issued and outstanding shares with full voting rights under all circumstances (paragraph 95(11)(d)), and
    • deeming each shareholder that owns shares of a tracking class to own a number of shares of the single class of the deemed separate corporation that is, in effect, in proportion to the shareholder’s economic interest in the income, losses and gains for the year deriving from the tracked property and activities (paragraph 95(11)(e)).

Specifically, paragraph 95(11)(e) deems each shareholder of the actual affiliate to own, at the end of the year, the percentage of the shares of the single class of the deemed separate corporation equal to the shareholder’s “aggregate participating percentage” (as defined in subsection 91(1.3)) in respect of the actual affiliate for the year, as determined under the following three assumptions (enumerated in subparagraphs 95(11)(e)(i) to (iii)):

  • that the actual affiliate were a CFA of that shareholder at the end of the year (this assumption is necessary to ensure that an aggregate participating percentage can be determined in respect of an actual affiliate that is not in fact a CFA of the shareholder, since subsection 95(1) defines “participating percentage” in respect of an entity that is a CFA of a taxpayer at year-end);
  • that the only shares of the actual affiliate at the end of the year were shares of tracking classes in respect of the tracked properties and activities (“tracking class” is defined for this purpose in subsection 95(10) – as a class of shares of the actual affiliate, the fair market value of which is determined by reference to the tracked property and activities – and can include classes none of the shares of which are owned by the taxpayer); and
  • that the only income, losses or gains of the actual affiliate for the year were those in respect of the tracked property and activities in respect of the taxpayer’s tracking interest. This is intended to ensure that each shareholder is deemed to own shares of the deemed separate corporation in proportion to the shareholder’s entitlement to the income from the tracked property and activities.

Where, based on the deeming rules in paragraphs 95(11)(d) and (e), the deemed separate corporation is a CFA of the taxpayer and the taxpayer is therefore subject to immediate accrual taxation in respect of its FAPI, the deeming rules in subsection 95(11)

  • facilitate the computation of that FAPI and the determination of the portion to be attributed to the taxpayer under subsection 91(1);
  • allow for the determination of any deductions available to the taxpayer under subsection 91(4) in respect of foreign tax paid; and
  • allow for the determination of the taxpayer’s reporting obligations under section 233.4, generally requiring the taxpayer to report on the separate corporation using the more detailed reporting requirements applicable to CFAs.

Otherwise, the normal rules in the Act in respect of foreign affiliates, in particular those dealing with the taxation of dividends received from a foreign affiliate, will continue to apply in respect of the actual affiliate. In order to ensure that amounts included in a taxpayer’s income under subsection 91(1) in respect of the deemed separate corporation, and any related amounts deducted under 91(4), are properly integrated with the taxpayer’s tax results in respect of the actual affiliate – and especially to avoid double taxation when amounts included in the FAPI of the separate corporation are ultimately distributed by the actual affiliate – paragraph 95(11)(f) deems such amounts to be included and deducted, respectively, by the taxpayer in respect of the tracking class of the actual affiliate. In particular, this is intended to ensure appropriate increases and deductions under subsection 92(1) to the adjusted cost base of shares of a foreign affiliate.

Tracking interests – controlled foreign affiliate

ITA 95(12)

New subsection 95(12) is one of the main operative rules introduced to address tracking arrangements in the context of foreign affiliates of Canadian taxpayers. It is intended to ensure that CFA status is not avoided where a taxpayer has a tracking interest in a foreign affiliate.

Subsection 95(12) is a residual rule that applies in cases where the “separate corporation” rule in subsection 95(11) does not apply because the conditions in subsection 95(10) are not met. More particularly, subsection 95(12) will not apply in respect of a foreign affiliate of a particular taxpayer for a taxation year of the affiliate if subsection 95(11) applies, in respect of the affiliate for the year, in respect of the particular taxpayer. Where two taxpayers have tracking interests in respect of an affiliate and subsection 95(11) applies in respect of one taxpayer, that does not preclude subsection 95(12) from applying in respect of the other taxpayer.

For more information, see the commentary on subsections 95(10) and (11).

Subsection 95(12) deems a foreign affiliate of a taxpayer to be a CFA of the taxpayer throughout a taxation year of the affiliate only if, at any time in the year, a tracking interest in respect of the affiliate, or a partnership of which the affiliate is a member, is held by:

  • the taxpayer; or
  • a person or partnership (referred to as a “holder”) that does not deal at arm’s length with the taxpayer.

Where either the taxpayer or a holder, or both, is a partnership, the rules in subparagraphs 95(12)(b)(ii) and (iii) look to the partnership(s) and members of the partnership(s) in order to determine non-arm’s length status.

The intention of subsection 95(12) is, where the conditions in that subsection are met in respect of a foreign affiliate of a taxpayer, to subject the taxpayer to immediate accrual taxation in respect of the affiliate under the FAPI regime.

New subsections 95(8) to (12) apply to taxation years of a foreign affiliate of a taxpayer that begin 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

Share on twitter
Twitter
Share on linkedin
LinkedIn
Share on facebook
Facebook
Share on google
Google+
Share on email
Email

Subscribe to our Newsletter

Stay up to date with daily tax developments.

Leave a Comment

Scroll to Top