Appendix B Technical Issues for Further Study
B.1 In this Appendix, we discuss technical issues arising from or related to the recommendations in the body of this report. We also point out some potential solutions to these issues that the government may wish to consider.
Taxation of outbound direct investment
Draft foreign affiliate technical amendments
B.2 The Department of Finance has proposed amendments to prevent taxpayers from creating exempt surplus inappropriately in certain types of inter-affiliate transactions and to consolidate surplus balances of foreign affiliates within a particular group. These proposals were first released on December 20, 2002, and revised proposals were released on February 27, 2004.
B.3 These proposals will add significant complexity to the current exempt and taxable surplus computations, increasing the compliance and administrative burden for taxpayers and the CRA. The Panel agrees with comments in submissions we received that these proposals are an “extreme reaction”143 to situations where only a relatively modest amount of tax is at stake.
B.4 Given the Panel’s recommendations to broaden the exemption system for active business income and to exempt capital gains and losses arising on the sale of shares of foreign affiliates that are excluded property, these particular proposed amendments should be abandoned, as there would be no need to compute surplus balances. The other foreign affiliate proposals released on February 27, 2004 and subsequently by the Department of Finance should be reviewed in light of the Panel’s recommendations.
Capital gains on sales of foreign affiliate shares: Additional considerations
B.5 This section elaborates on some issues and possible alternatives the government should consider in extending an exemption to capital gains on the sale of shares of foreign affiliates.
Excluded and non-excluded property
B.6 The current “excluded property” definition includes a point-in-time test. Under a broader exemption system that exempts capital gains on the sale of shares of a foreign affiliate that are excluded property, businesses will want to ensure that such dispositions qualify for the exemption at that point in time. Anti-avoidance rules may be needed to prevent transactions designed to qualify foreign affiliate shares as excluded property in inappropriate circumstances.
B.7 For example, a foreign affiliate could purchase active business assets immediately before a sale that are unrelated to its active business for the principal purpose of qualifying the foreign affiliate’s shares as excluded property and thus eligible for the exemption. The purchased assets would not represent a bona fide investment by the taxpayer in an active business because they would not have been acquired primarily for business reasons. The Panel believes such transactions are inappropriate and should be subject to an anti-avoidance rule.
B.8 A different set of transactions could involve a company disposing or otherwise removing non-excluded property assets from a foreign affiliate that is being disposed of so that its shares would be considered excluded property at the time of sale. Unlike the transactions described above, this planning seems appropriate and should not be subject to an anti-avoidance rule.
Holding period
B.9 The current rules impose no holding period requirements in assessing whether shares of a foreign affiliate qualify as excluded property. In a broader exemption system, a minimum holding period may be considered appropriate to ensure the exemption does not extend to situations where the investment in the foreign affiliate is merely a temporary passive one. This approach could also appropriately restrict the exemption where additional shares are acquired immediately before a sale for the principal reason of qualifying the foreign corporation as a foreign affiliate. However, as noted in paragraph B.8, the Panel believes it should not be necessary for the shares to derive all or substantially all of their value from active business assets throughout the holding period.
Dividend stripping
B.10 If the exemption system is broadened to cover dispositions of foreign affiliate shares, additional changes may be required to address the inappropriate reduction of a capital gain arising on the sale of shares of either a Canadian corporation or a foreign affiliate.
B.11 In practice, the link between retained earnings (referred to as “safe income”), dividends and capital gains is important because safe income can reduce a capital gain otherwise arising on a sale of the corporation’s shares. This reduction can occur where a Canadian corporation disposes of the shares of another Canadian corporation and, under the current rules, where there is a disposition of the shares of a foreign affiliate.
B.12 The tax policy rationale for this treatment is that the portion of the capital gain that is derived from a corporation’s safe income should not attract capital gains tax as this amount has already been subject to corporate income tax. In other words, only the portion of the capital gain that represents capital appreciation unrelated to retained earnings should attract capital gains tax. Under the current rules, the surplus accounts form the basis for determining the safe income of a foreign affiliate.
B.13 In a system that exempts the capital gain on the disposition of shares of a foreign affiliate but taxes capital gains from the disposition of shares of a Canadian corporation that has an interest in a foreign affiliate, the computation of safe income of a foreign affiliate should be considered. There may be an inclination to retain the current surplus computation rules for this purpose. However, there may be simpler alternatives. For example, consideration could be given to increasing the safe income of the Canadian corporation by an appropriate amount representing the accrued gain attributable to foreign affiliate shares that are excluded property and previous dividends from these foreign affiliates.
B.14 If safe income of a foreign affiliate were to continue to be measured, simpler ways of measuring it should be considered, for example, by referring to financial statements of the foreign affiliate. The limitations of using financial statements should be weighed against the benefits of eliminating the need for businesses to perform additional complex calculations that in many circumstances may not provide a number that is substantially different from, or more accurate than, the financial statement amounts.
B.15 Additional changes should probably be considered independent of the choices made regarding the computation of safe income of a foreign affiliate. For example, the current anti-avoidance rule to address dividends paid on the shares of a Canadian corporation in excess of safe income could be extended to cover dividends paid from foreign affiliates. The rule may have to be tailored to operate differently depending on whether the foreign affiliate shares are excluded property.
B.16 For example, where the shares are not excluded property, an anti-avoidance rule could apply where dividends on the foreign affiliate shares inappropriately reduce a capital gain on those foreign affiliate shares. However, where the foreign affiliate shares are excluded property (and so any gain on those shares would be eligible for an exemption), the matter is more complicated. Depending on which system the government chooses for computing the safe income of a foreign affiliate, additional guidance may be required to ensure that dividends from foreign affiliates do not inappropriately increase the safe income of an upstream Canadian shareholder.
Foreign affiliate reorganizations: Eliminating potential FAPI
B.17 The current and proposed rules involving foreign affiliate reorganizations are extremely complicated. In certain circumstances under these rules, foreign affiliate reorganizations that do not change the overall economic ownership of the affected affiliates can still result in FAPI.
B.18 In many circumstances, a reorganization can be undertaken or carried out in a specific way for foreign tax or foreign corporate law reasons. The Panel believes that, in principle, FAPI should not be realized in reorganizations where the overall economic ownership of the affected affiliate and its assets remains the same.
B.19 The Panel expects that our recommendations to move to a broader exemption system for active business income and to exempt gains and losses arising on the sale of shares of foreign affiliates that are excluded property will simplify the current provisions dealing with reorganizations of foreign affiliates. The Panel recommends amending these rules to ensure FAPI does not arise in reorganizations where the overall economic ownership of the affected affiliate and its assets does not change.
Transitional rules: Taxable surplus
B.20 Under a broader exemption system, companies would no longer need to track exempt or taxable surplus of their foreign affiliates. Dividends would be exempt from taxation, as would gains from the disposition of foreign affiliate shares that are excluded property.
B.21 A question arises as to treatment of existing exempt and taxable surplus balances at the time of the change to a broader exemption system. A number of options could be considered, including a complete amnesty or a moderate toll charge for the repatriation of taxable surplus. Other options tend to be complicated and could create further tax policy issues.
B.22 Because the current system generates little tax revenue from dividends paid out of taxable surplus, the Panel would support a complete amnesty from Canadian tax for amounts accumulated in the taxable surplus balances of those affiliates whose shares will qualify as excluded property under the recommended broader exemption system. Special consideration may need to be given to foreign affiliates whose shares are not excluded property.
Changes to the “excluded property” definition: Additional considerations
B.23 A foreign affiliate’s “excluded property” includes its property used or held principally to earn active business income and its shares of another foreign affiliate where all or substantially all of the fair market value of the other affiliate’s property is attributable to excluded property of that affiliate.
B.24 The Panel recommends that capital gains arising on the sale of shares of a foreign affiliate be exempt if the shares are excluded property. To maintain the integrity of a broader exemption system, the definition of “excluded property” should be robust enough to ensure shares are appropriately classified as excluded property or not. In Chapter 4, we discuss certain changes to the “excluded property” definition that would need to be considered. We now identify other considerations.
Multiplier effect
B.25 In determining the status of the shares of a higher-tier company in a chain of foreign affiliates, the current “excluded property” definition requires a taxpayer to first determine the status of the shares of bottom-tier affiliates. The status of the shares of the next higher-tier affiliates is then determined, taking into account the status of the shares of the lower-tier affiliates that it owns. This approach can produce anomalous results.
B.26 If a lower-tier affiliate has excess “investment assets” (more than 10 percent of its total assets), the entire fair market value of the shares of the lower-tier affiliate will be considered a tainted asset for the purpose of determining the excluded property status of the shares of the higher-tier affiliate that owns them. This process is repeated up the chain of affiliates and can cause a top-tier affiliate to fail the excluded property test even if the amount of investment assets held by the affiliate and lower-tier affiliates is not excessive when viewed on a consolidated basis.
B.27 In other situations, a chain of foreign affiliates could have excess investment assets when viewed on a consolidated basis, yet the shares of the top-tier affiliate could still satisfy the excluded-property test because of the bottom-up analysis inherent in the current definition.
B.28 The Panel believes the definition of “excluded property” should be modified to take a more consolidated approach, considering the property of the entire underlying group and not of a single affiliate. In applying the excluded property test at any particular level within a chain of foreign affiliates, the property of all underlying entities should be divided into excluded property and non-excluded property. If the value of the group’s excluded property comprises all or substantially all of the total value of the group’s property, then the shares of the top affiliate would constitute excluded property. Such group determination could be done on a country-by-country basis.
Temporary excess investment assets
B.29 At times, foreign affiliates will have temporary excess cash or investment assets on hand, possibly arising from the sale of certain business units or from its operations. The presence of such assets can make it difficult to determine whether the shares of the affiliate are excluded property. In some cases, the cash or investment assets may not be excess to the business because they are being held to make a strategic acquisition. For a variety of reasons, such as expected fluctuations in interest rates, it may be preferable to hold such assets rather than retire existing debt.
B.30 From a policy perspective, it seems reasonable that property, such as cash or other short-term investments, that is held for a reasonable time period to fund an acquisition of excluded property should not preclude the shares of the corporation holding the short-term investments from being considered excluded property.144
Certification for withholdings under regulations 102 and 105
B.31 In Recommendation 7.3, the Panel calls for Canada to eliminate withholding tax requirements related to services performed and employment functions carried on in Canada where the non-resident certifies the income is exempt from Canadian tax because of a tax treaty. Such a certification system could be implemented as follows:
- To claim a reduced or zero rate of withholding, the non-resident could file a short form with the payer certifying the income is exempt. The certification form would capture data about the non-resident, including business and personal information (such as corporate names, addresses and foreign country tax identification numbers), so the CRA can obtain more information if needed.
- The payer would review the form to assess whether the exemption from withholding is warranted. The payer would reject the form if the payer knew or had reason to know that any of the facts or statements on the form may be false or that the non-resident’s exemption from withholding could not be readily determined.
- The payer would file with the CRA an information return reporting the transactions, along with a copy of the certification form.
- Preferably, the non-resident could use its treaty country tax identification number, eliminating its requirement to obtain a Canadian Social Insurance Number, business number or tax identification number; however, this may not be possible in all cases.
- The non-resident would file a tax return at year-end if the amounts paid or payable by all Canadian payers exceeded a specified threshold.
Providing investment advisory services to non-residents
B.32 Section 115.2 of the Act specifies the activities a Canadian investment fund manager can undertake on behalf of a non-resident without causing the non-resident to be treated as carrying on business in Canada. The Canadian investment fund manager can offer services in respect of most Canadian securities other than unlisted securities that derive their value principally from Canadian real estate, resource or timber resource property.
B.33 The Panel understands that the carve-out for such securities poses challenges for Canadian investment fund managers competing for mandates from non-residents. At the same time, the Panel recognizes that there may be technical reasons for excluding certain securities and believes that consultation would be required to assess whether further relief should be provided. The same would be true on considering whether relief should extend to related parties and partnerships of which non-residents are members.
143 Submission of Deloitte & Touche LLP to the Advisory Panel on Canada’s System of International Taxation, at p. 4.
144 A similar position can be considered to have been taken in the proposed rules dealing with FIEs. Under the definition of “exempt property” in those rules, exempt property of a non-resident entity is property of the non-resident entity that is being accumulated (for not more than 36 months or such longer period approved by the Minister of National Revenue) for active business use or for acquiring equity interests in active business entities. Exempt property is treated as not being investment property for the purpose of determining a non-resident entity’s classification as a foreign investment entity. A similar provision could apply for FAPI purposes.