Canada Revenue Agency (CRA) issues tax ruling on cash repatriation strategy

On 5 May 2010, the Canada Revenue Agency (CRA) issued an important tax ruling sanctioning a specific cash-repatriation strategy from Canada. While the tax ruling is only binding with respect to the particular taxpayer that requested it, it is nonetheless indicative of the CRA's current administrative practice and should be helpful for taxpayers wishing to implement similar strategies.

Although the published version of the ruling is redacted to remove confidential taxpayer information, the basic fact pattern is sufficiently clear.

A Canadian corporation (Canco), an indirect wholly-owned subsidiary of a US parent company (Parentco), had excess cash that it wished to redeploy elsewhere in the Parentco group. The ruling indicates that Canco initially contemplated paying a dividend to Parentco, but that such a dividend would have adverse US tax consequences. In addition, the ruling indicates that a loan from Canco to Parentco would have triggered Canadian withholding tax under subsection 15(2) of the Income Tax Act. In general, subsection 15(2) provides that a loan from a Canadian corporation to its shareholder (or any person "connected" with the shareholder, such as a sister corporation) is recharacterized as a deemed dividend. If the shareholder (or connected person) is a nonresident, the deemed dividend is subject to Canadian withholding tax.

Although deemed dividend treatment only applies if the loan is not repaid within one year after the end of the lender's taxation year in which the loan arose, a specific anti-avoidance rule generally prevents repayments followed by new loans. In addition, the deemed dividend rule under subsection 15(2) applies regardless of whether the loan bears interest at an arm's-length rate.

In an effort to avoid Canadian withholding tax (and adverse US tax consequences), Canco proposed the following series of transactions in the ruling:

1. Canco incorporates a new foreign subsidiary (Financeco) and capitalizes Financeco with equity and mandatorily redeemable preferred shares (MRPS). The ruling indicates that the MRPS are treated as equity for Canadian tax purposes, and as debt for tax purposes in Financeco's jurisdiction.
2. Financeco uses the funds received from Canco to make an interest-bearing loan (Loan 1) to another indirect wholly-owned foreign subsidiary in the Parentco group (Loanco). Loanco is described as a group financing company.
3. Loanco uses the proceeds from Loan 1 to make loans to other non-Canadian and non-US entities in the Parentco group.

Among other things, the ruling confirms that redeployment of excess Canadian cash in this manner will not result in a deemed dividend from Canco under subsection 15(2) and, more important, that the general anti-avoidance rule (GAAR) will not apply to the proposed series of transactions.

Although the ruling indicates that interest on Loan 1 will be taxable in Canco as foreign accrual property income (FAPI), in many cases this should be immaterial in relation to the ability to avoid dividend treatment out of Canada.

The ruling does not address the foreign tax consequences of the proposed structure, but presumably these can be adequately managed in most situations.

In the end, the net effect of the structure described in the ruling is that a Canadian company may be able to redeploy excess cash outside the Canadian group without paying a dividend and without running afoul of subsection 15(2). The CRA's decision not to apply GAAR to a repatriation strategy designed to avoid subsection 15(2) may provide a meaningful degree of comfort to other taxpayers interested in implementing similar strategies.