Canada provides a participation exemption (exempt surplus) on repatriation of earnings from foreign affiliates. Canada simultaneously provides interest deductibility for amounts borrowed to invest in shares of foreign affiliates. Additionally, in our tax treaties, Canada typically requires five per cent or more withholding tax on dividends paid by Canadian companies to foreign parent corporations.
In the past, multinational parent companies wishing to extract surplus from a Canadian subsidiary could implement planning to sell or “dump” the shares of their non-Canadian subsidiaries to the corporation resident in Canada (CRIC) in exchange for cash and/or an interest-bearing vendor-take promissory note. The cash or promissory note paid was not subject to withholding tax. The interest on debt would shelter the taxable income of the Canadian operating company. Canada receives no withholding tax on the cash payment and reduced income tax on future business profit. Withholding tax would be collected if interest were paid on the vendor take-back note because the debt would be owed to a non-arm’s-length party.
Foreign Affiliate Dumping rules were announced in 2011 to combat the tax-free extraction of surplus when a CRIC that is controlled by a non-resident corporation, invests in a foreign affiliate. (Similar rules target loans made by a CRIC to non-arm’s-length non-resident members of a corporate group.)
These rules generally deem that where a foreign affiliate is acquired by a CRIC (or the CRIC makes a loan to a non-arm’s-length non-resident), either the cross-border paid-up capital of the CRIC is suppressed (ground down), or a dividend is deemed to have been paid by the CRIC to the foreign parent corporation.
Currently, the rules only apply where the CRIC is controlled by a foreign corporation or group of foreign corporations.
The Budget proposes to extend the rules to CRICs that are controlled by non-resident individuals and trusts or groups of persons that do not deal at arm’s-length with each other, that comprise any combination of non-resident corporations, individuals or trusts. For the purposes of determining if a non-resident trust is “related” and therefore not at arm’s-length with other parties, the trust will be deemed to be a corporation and the beneficiaries will be deemed to be shareholders that own shares pro-rata to the relative value of their beneficial interests in the trust.
Presumably the measure is aimed at CRICs that are owned by non-resident private equity funds or possibly high-net-worth families that structure their foreign-holding entities as trusts or partnerships rather than corporations.
This measure will apply to transactions or events that occur on or after March 19, 2019.
Order of application of transfer-pricing rules
Transfer-pricing rules in the Income Tax Act generally provide that, where a Canadian taxpayer transacts with non-arm’s-length parties outside Canada, the price used for the transaction must be established using the arms’-length principle. That is, the parties must establish a price that is within the range that arms’-length third parties would have used had they transacted under the same terms and conditions.
The Income Tax Act contains other provisions which may require adjustment to the income reported on a transaction. Questions arose regarding whether adjustments were made pursuant to general transfer-pricing rules or other more specific provisions. In these situations, it was not clear whether transfer-pricing penalties were applicable.
The Budget proposes that the transfer-pricing adjustments shall apply in priority to any other adjustments required under the Act. Presumably, any applicable transfer-pricing penalties will apply in these situations.
Current exceptions to the transfer-pricing rules (for example subsection 17(8) which permits certain zero or low interest loans made to controlled foreign affiliates) are retained.
This measure applies to taxation years commencing after March 19, 2019.
Reassessment period for transfer-pricing “transactions”
The definition of “transaction” for transfer-pricing purposes is expanded beyond the normal meaning of that word.
The Income Tax Act provides an extended three-year reassessment period beyond the usual reassessment period for transfer-pricing adjustments. However, the definition of “transaction” for reassessment purposes was not the expanded definition used for transfer-pricing purposes.
The Budget proposes to use the expanded definition of “transaction” in determining whether that transaction can be reassessed in the extended three-year reassessment period.
This measure applies to taxation years for which the normal reassessment period ends on or after March 19, 2019, meaning it applies to most transactions that have occurred in the last three to four years.
No new legislative changes were announced related to BEPS.
The government reaffirmed its commitment to actively participate in the OECD’s BEPS initiatives. Canada is participating in the review of the country-by-country reports first exchanged in 2018 with other governments and tax authorities. The review is expected to be complete in 2020.
The government reaffirmed its commitment to ratify and bring into force the Multilateral Convention to Implement Tax Treaty Related Measures to prevent BEPS (commonly known as the Multilateral Instrument or MLI).
Securities lending occurs commonly in our capital markets, often seen when investors wish to short-sell securities that are expected to decrease in value.
A Canadian resident might borrow the shares of a public company from a non-resident lender. The Canadian would be required to make compensatory payments to the lender equal to any dividends paid on the borrowed shares and might be required to post collateral to secure the return of identical shares to the lender. If the borrowing is “fully” collateralized (defined to mean at least 95 per cent of the value of the borrowed security is collateralized with money or government debt obligations) the compensatory payment is considered a dividend and is subject to the normal dividend withholding taxes. When not fully collateralized, the compensatory payment is treated as a payment of interest, which is not subject to withholding tax if paid to arm’s-length parties.
The Act contains rules intended to ensure the lender is in the same tax position as if the securities had not been lent, including with regards to Canadian withholding taxes on compensatory payments.
Where the borrowed security is a share of a Canadian corporation, the Budget proposes to treat all compensatory payments as dividends (regardless of whether fully collateralized). Thus, the dividend withholding rules will come into effect.
Under these proposed rules, the “lender” is deemed to be the recipient of the dividend, the security issuer is deemed to be the payer of the dividend, and the lender is deemed to own less than 10 per cent of the votes and value of shares of the issuer, meaning that the five per cent withholding rate in many treaties will not be accessible and a higher (often 15 per cent) withholding rate will apply.
The Budget also expands the application of these rules to “specified securities lending arrangements,” a concept introduced in 2018 to prevent the creation of artificial losses.
Where the borrowed security is a share of a non-resident issuer (a foreign corporation), the current rules require withholding tax on the compensatory dividend payment. However, the non-resident lender would not have been subject to Canadian withholding tax on receipt of a dividend from the non-resident issuer corporation. As a relieving provision, the Budget proposes to expand the exemption for withholding (subsection 212.1(2.1)) to any dividend compensatory payment paid by a Canadian resident borrower to a non-resident lender where the arrangement is fully (95 per cent) collateralized.
These new rules apply to payments made after March 19, 2019. For securities loans in place on March 19, 2019, the amendments apply to compensatory payments made after September 2019.
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