TAX NEWS - DECEMber 2009

Foreign affiliates: Draft amendments released 18 December 2009

On 18 December 2009, the Department of Finance released a 112-page package of draft legislation, regulations and explanatory notes concerning the foreign affiliate rules under the federal Income Tax Act (the Release). The Release includes revised foreign affiliate regulations required to support legislation that was enacted by Bill C-28 on 14 December 2007.

These measures implemented many of the foreign affiliate proposals announced on 27 February 2004 — which, in turn, represented a redraft of measures initially proposed on 20 December 2002. However, the Release also includes other draft amendments, as well as revised rules on filing various elections with respect to the retroactive application of certain provisions enacted by Bill C-28, which must be made by 31 December 2009 by taxpayers with calendar taxation years.

The Release does not include any update to the so-called "internal disposition" or foreign affiliate "distribution" and "reorganization" proposals that were contained in the 27 February 2004 package, although it is noted in the Explanatory Notes to the Release that further proposals to deal with any outstanding measures contained in that package are expected in the near future.

The Department of Finance will accept comments until 15 February 2010, after which it states that it intends to implement the proposed legislation at an early opportunity.

This Tax Alert summarizes the principal measures included in the Release and certain actions that taxpayers should consider at this time. It is not intended as a comprehensive review of the Release. Further review may well expose additional considerations.


Retroactive application of Bill C-28

Bill C-28 enacted a number of relieving provisions, with application dates that generally correspond to the dates when these provisions were first announced. However, the legislation also provides for certain retroactive application dates, rendering these provisions (and the supporting draft regulations, where applicable) effective back to 1994, where the taxpayer files the required election(s). The Release would implement an extension of the time for filing such elections by taxpayers with calendar taxation years — to 31 December 2009 — as announced in June 2008. The Release would also allow such elections to be revoked — until 30 June 2011 for calendar year taxpayers. Later deadlines, for both elections and revocations, generally apply for taxpayers with non-calendar year ends.


Surplus accounts

The Release includes a number of proposals that would rewrite and simplify many of the existing or previously proposed computation and adjustment rules for surplus and other accounts that apply in various contexts involving direct and indirect acquisitions and dispositions of the shares of a foreign affiliate (contained mostly in Regulations 5902 and 5905).


Subsection 93(1) deemed dividends

With respect to the computation and adjustment consequences of a deemed dividend arising under subsection 93(1) of the Income Tax Act (the Act) (draft regulations 5902(1) and (2), and related provisions), the Release would abandon the complicated approach proposed in February 2004. It would instead return to the more traditional approach reflected in the current rules, relying on the mechanism of computing the relevant top-tier affiliate's accounts using a hypothetical full-distribution model (whereby lower-tier affiliates are deemed to fully distribute their "net surplus" to higher-tier affiliates until the surplus reaches the relevant top-tier affiliate) and then accounting for the "use" of such surplus (at all tiers) by making a negative adjustment — and, possibly, creating a "blocking deficit" — in the accounts of the relevant top-tier affiliate.

In addition, to prevent taxpayers from causing lower-tier surplus to bypass higher-tier "blocking deficits" by reorganizing groups of foreign affiliates, the Release would introduce what may be described as certain "out-from-under" rules (under new Regulation 5907(7.2) and related provisions), whereby negative surplus adjustments (coupled with positive adjustments to the holder's cost in the relevant shares) could be made where a "deficit affiliate" disposes of the shares of a lower-tier affiliate having a "tax-free surplus balance."


Acquisitions of control

As suggested in the Explanatory Notes published with Bill C-10, which enacted certain additional amendments to the foreign affiliate rules on 12 March 2009 (aimed primarily at income and gain computation issues), the Release includes proposals (new subsection 5907(5.2) and related Regulations) that would reduce a foreign affiliate's "exempt surplus" and other accounts in respect of a corporation resident in Canada, with a view to eliminating "excess" tax attributes, where control of the corporation has been acquired. Essentially, the proposals would reduce certain of the affiliate's accounts in respect of the corporation to the extent that the aggregate of the corporation's cost amount in the shares of the affiliate (determined after taking into account the application of subsection 111(4) of the Act), and the affiliate's "tax-free surplus balance," exceeds the fair market value of the shares of the affiliate at the time of the acquisition of control. For these (and other) purposes, the affiliate's "tax-free surplus balance" would be determined (under new Regulations 5907(5.5) and (5.6)) on a consolidated basis in the same manner as for subsection 93(1) deemed dividends, using the hypothetical full-distribution model applicable under current rules. The "tax-free surplus balance" would include the amount of the affiliate's distributable "exempt surplus," and its distributable "taxable surplus" to the extent fully covered by "underlying foreign tax."

In contrast to the February 2004 proposals in this regard (which the Release provides would apply on a transitional basis until 18 December 2009), the new proposals would not effect an across-the-board reset of the affiliate's accounts (for example, "exempt deficit" accounts, net of any surplus accounts, would not be adjusted), nor would adjustments be contingent on any amount being designated in respect of the affiliate's shares under paragraph 88 (1)(d) of the Act.

Nevertheless, an affiliate's "tax-free surplus balance" would also reduce the amount by which the "cost" of its shares to a corporation resident in Canada could be increased, in accordance with a proposed amendment to subparagraph 88(1)(d)(ii), which (together with corresponding regulations) would replace the previously proposed paragraph 88(1)(d.4).

In light of these measures, taxpayers contemplating an acquisition of control should consider the possibility of preacquisition planning that could maximize the value of foreign affiliate tax attributes that would otherwise expire on the acquisition of control.


Active business income re-characterization rules

The Release includes revised Regulations relating to the treatment for surplus account purposes of amounts that are re-characterized as active business income under paragraph 95(2)(a) of the Act, under the definition of "exempt earnings" and related provisions.

The Release also revises measures (in former proposed subsection 5907(2.8) of the Regulations) that would have adjusted lower-tier surplus accounts in relation to payments by higher-tier affiliates that are re-characterized as active business income to the recipient under clause 95(2)(a)(ii)(D) of the Act. The new measures would continue to apply in a way that reduces the surplus of (or creates a deficit in) the top-tier affiliate, but would abandon the "deficit push-down" aspect of the former proposals.


Capital gains

The Release includes revisions to the definitions in the Regulations of "exempt earnings" and "net earnings" (as well as related definitions) that are designed to account for the 50% "tax-free" portion of certain capital gains realized by foreign affiliates. The revisions would also restrict to 50% the "exempt earnings" arising from a disposition of "excluded property" where the property gives rise to re-characterized active business income that has its source (or relates to a source) in a non-designated treaty country.


Partnerships

The Release would introduce a new set of rules (under new Regulation 5908) to address various surplus computation and adjustment issues that arise where the shares of a foreign affiliate are held in partnership — including, among others, adjusted cost base determination issues — as well as to support the application of more general rules, such as those in Regulations 5902, 5905 and 5907.


Currency issues

As expected, the Release includes a revised Regulation 5907(6) that, in appropriate cases, would permit a foreign affiliate's surplus and other accounts to be maintained in Canadian dollars.


Residence in a designated treaty country

The Release proposes to introduce a "throughout the year" requirement with respect to a foreign affiliate being resident in a "designated treaty country" for the purpose of determining the affiliate's "exempt earnings." This would represent a change to current practice, by which it is accepted that the residence requirement need only be met at the end of the affiliate's year.


Foreign accrual property losses

The Release includes a revised section 5903 of the Regulations, which would mainly govern the use of "foreign accrual property losses" in other years. The proposals would implement a new
regime that provides for a 20-year carry-forward and a three-year carry-back mechanism.

The Release would also revise proposed subsection 5907(1.4) of the Regulations, which would restrict the prescribed "foreign accrual tax" arising from certain payments made within a group of foreign affiliates that benefit from a foreign consolidation or group relief regime. Such payments would qualify only to the extent that they can reasonably be considered to relate to a foreign accrual property loss of another controlled foreign affiliate of a relevant person or partnership in respect of the taxpayer.

Under another proposed revision, the computation rules in Regulation 5907(1.1) would be modified to address circumstances in which a foreign affiliate that is part of a consolidated group of entities makes a payment for the use of a foreign tax credit (as opposed to a loss) of another member of the group.


Other measures

Regulated financial institutions

The Release contains a number of measures that would replace provisions in various rules that determine whether or not a foreign affiliate's business (or certain of its activities) can be excluded from the scope of the "investment business" definition or from "base erosion" rules such as those in paragraph 95(2)(a.1), where the relevant activities are "regulated." Under these proposals, it would be sufficient for the activities to be regulated under the laws of the country under whose laws the affiliate is governed as a matter of corporate law, and of each country in which the business is carried on through a "permanent establishment" (which expression would be redefined under the Release).


Foreign oil and gas levies

The Release also includes proposed new Regulation 5910, which is designed to treat certain foreign oil and gas levies as foreign taxes for certain purposes.


Actions to consider

Taxpayers considering making any of the elections contemplated by the Release — in particular, the elections provided for in Bill C-28 — should determine whether or not such elections are advisable and, if so, should ensure that they are filed in time: for calendar-year taxpayers, these elections must be filed by the end of December 2009.

Taxpayers involved in an indirect foreign affiliate acquisition should also consider the advisability of certain preacquisition planning that may permit the efficient use of foreign affiliate tax attributes that would otherwise expire on the acquisition.

There are many other proposals in the Release that are effective after 18 December 2009. Accordingly, taxpayers should consider the impact of these proposals on existing foreign affiliate structures, and whether any consequential structural changes would be advisable.

Taxpayers may also consider whether or not the proposals in the Release raise any issues that should be raised with the Department of Finance during the consultation period to 15 February 2010.