With the release on August 19, 2011 of a package of legislative proposals dealing with the taxation of Canadian businesses with foreign subsidiaries, the Department of Finance has replaced a number of previously enacted proposals and clarified things in a number of important areas and seems to have embarked on a course that will lead to clearer planning possibilities for small and mid-sized Canadian businesses operating outside Canada. Nevertheless, with the numerous sets of “rules” that have been introduced over the past seven years, it is clearly time to take stock of your tax compliance and planning in areas such as accounting for various types of foreign source active business (surplus) and non-active (foreign accrual property or FAPI) income. These changes will also impact any plans you have for reorganizing foreign subsidiaries and will substantially impact any plans you may have for repatriating foreign source income to Canada, particularly if it is by way of dividends, returns of capital or upstream loans. Needless to say, these changes will also significantly impact your tax accounting and deferred tax balances.
Surplus Accounting and FAPI
With the new proposals, surplus accounting for your foreign affiliates is going to get more complicated. A series of proposals starting in 2002 attempted to deal with the artificial creation of exempt surplus through internally generated transactions involving dispositions of property The proposals in 2002 and 2004 created regimes that were complicated and created much uncertainty in relation to the consequences of many foreign affiliate reorganizations. The August 2011 proposals take an alternative and less complicated approach by creating a “hybrid surplus” category. When a qualifying internal disposition takes place, both the exempt and taxable portions of any gain form a single “hybrid” surplus balance and are distributed together upon repatriation to the Canadian taxpayer. The surplus ordering rules are modified so as to make distributions out of hybrid surplus second only to exempt surplus. After 2012 this hybrid surplus would arise on internal dispositions of any shares that are considered “excluded property” including shares of another foreign affiliate, a partnership interest or other related types of property that do not give rise to FAPI on disposition. Prior to 2012, the treatment only applies to a limited category of dispositions.
The computation of FAPI is also going to be more challenging with the new proposals. FAPI generated on disposition of capital property is now going to be streamed, similar to the system for domestically generated capital and non-capital gains and losses. This will prevent the generation of FAPI capital losses that can otherwise be utilized to shelter FAPI business income in the future. Losses will now be streamed as FAPL (foreign accrual property losses) and FACL (foreign accrual capital losses), with the latter only applied against foreign accrual capital gains.
Internal Reorganizations
The August 2011 proposals also give some clarity and symmetry to the rules for foreign affiliate reorganizations. There are new rules dealing with first tier transactions or liquidations and dissolutions of a foreign affiliate resulting in a distribution of property to a Canadian shareholder. There are also new rules dealing with second tier liquidations and dissolutions of a foreign affiliate which lead to a distribution of property to an upper tier foreign affiliate within the same Canadian taxpayer group. There are elections available and new thresholds to meet to come within the rollover provisions in the Canadian Act. There are also new provisions dealing with mergers between foreign affiliates, including a rule to bring US “absorptive” mergers within the foreign affiliate merger rules.
Repatriation Planning
Canadian taxpayers are going to have to reconsider their repatriation planning if they relied on the use of tax-free returns of capital or upstream loans to move funds in a tax-efficient manner to their Canadian parent companies.
The August 2011 proposals have eliminated the use of returns of capital from foreign subsidiaries as a tax-effective means for repatriating funds to Canada or to upper tier subsidiaries. For Canadian tax purposes, these returns of capital are now treated as dividends and are taxed accordingly unless the return of capital is received in relation to the liquidation of a foreign affiliate or on a redemption of its shares. Taxpayers will, however, be given some relief if they have adjusted cost base in the shares of the foreign affiliate making the return of capital. An election is available to treat the “dividend” as a return of adjusted cost base.
As noted earlier, the August 2011 proposals also introduced a regime for the taxation of upstream loans from foreign affiliates to their Canadian parent. These loans were typically used by taxpayers to repatriate (low taxed taxable surplus) earnings otherwise subject to significant incremental tax upon receipt as a dividend in Canada. The new provisions will bring offending loans into income of the Canadian taxpayer under certain circumstances, but there are certain exceptions and relieving provisions. Of particular concern, however, is that the provisions are drafted quite broadly and there is general concern that they may also apply to certain inter-affiliate lending arrangements and even certain cash pooling arrangements, and so hamper normal course planning within a foreign affiliate group. The Department of Finance has already indicated that they are prepared to go after any planning that they would consider an avoidance transaction.
Tax Accounting Issues
When these legislative proposals do become substantively enacted, there will be a number of accounting and reporting implications that will arise out of the computation of current and deferred taxes as well as any note disclosures that will be required under IFRS. As discussed earlier, the changes to the composition and balances of surplus accounts will impact any deferred taxes that will arise on repatriation of the earnings of your foreign affiliates. The new provisions around upstream loans will change the timeline for temporary differences and may, in fact, change the time period over which temporary differences will reverse. Canadian companies will have to determine if and how to disclose the impact of the proposals on their deferred tax balances. Most importantly, the new proposals may have their greatest impact by removing or introducing new uncertainties around past or future filing positions.
Taking Stock
In essence, if you have foreign businesses that are owned by a Canadian entity, it is time to take stock of your Canadian tax compliance and planning as it relates to surplus accounting and FAPI, internal reorganizations involving foreign operations and repatriation of foreign earnings to Canada, all of which will significantly impact your tax accounting.
For more information, please contact Tim Bloos, CA
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