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TAX NEWS - may 2010

Canada Tax: New Canadian reporting requirements for tax avoidance transactions proposed

The Canadian Finance Minister has released details of a proposed new reporting requirement for certain tax-avoidance transactions. Although the proposals are not as far-reaching as those recently announced in Quebec, they would represent one of the most significant federal legislative tools for tackling tax avoidance since the introduction of the general anti-avoidance rule in 1988.

The detailed proposals suggest broader measures than those outlined in the budget. In particular, not only taxpayers who engage in certain tax avoidance transactions would be subject to the reporting requirements, but also tax advisors and promoters. Further, all parties who fail to disclose as required potentially would be jointly and severally liable for penalties, subject to individual liability caps and a due diligence defense.

The purpose of the proposed rules is to assist the Canada Revenue Agency in identifying aggressive tax planning in a timely manner so that the application of the general anti-avoidance rules can be considered.

However, the proposals state that the disclosure of a reportable transaction would not constitute an admission that the general anti-avoidance rule applies to the transaction, or that the transaction is an avoidance transaction. This seems contradictory, since the proposals also maintain that a transaction must be an "avoidance transaction" in the first place in order to be a reportable transaction.

In order to be reportable, a transaction would have to be an "avoidance transaction" as defined for the purposes of the GAAR in subsection 245(3). In general, this is a transaction that results in a tax benefit, either by itself or as part of a series of transactions, unless the transaction may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit.

An "avoidance transaction" would be reportable if it had at least two of the following three hallmarks:

- The promoter or tax advisor was paid a "contingency fee";
- The promoter or tax advisor required "confidential protection" with respect to the transaction; and/or
- "Contractual protection" was provided to the taxpayer.

Flow-through shares and tax shelters would be exempt from the new rules, however, since they already have their own reporting regimes.

The failure to report an avoidance transaction would result in the suspension of the associated tax benefit, although the tax benefit could be reinstated if the taxpayer files with the Canadian Revenue Agency the information that should have been reported and pays the requisite penalty.

If enacted, the new regime would apply to transactions entered into after 2010 and to any part of a series of transactions completed after 2010. Interested parties have until 7July 2010 to comment on the proposals.

The proposed reporting requirement would represent a significant new tool in the Canadian tax authority's information-gathering arsenal. If enacted, it would likely result in an increase in audit activity. The proposals leave some important questions unanswered, however, particularly as to the specific information that would be required to be disclosed and how solicitor-client privilege would be affected. Ernst & Young LLP, Canadian Tax Desk - Nik Diksic and Andrea Lepitzki (New York)

Canada Revenue Agency issues tax ruling on cash repatriation strategy

The Canada Revenue Agency (CRA) on 5 May 2022 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 considered in the ruling 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 re-deploy 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 (Canada). 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 taxation year of the lender 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 (Loan1) 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 Loan1 to make loans to other non-Canadian and non-US entities in the Parentco group.

Among other things, the ruling confirms that re-deployment of excess Canadian cash in this manner will not result in a deemed dividend from Canco under subsection 15(2) and, more importantly, that the general anti-avoidance rule (GAAR) will not apply to the proposed series of transactions. Although the ruling indicates that interest on Loan1 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 re-deploy 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. Ernst & Young LLP, Canadian Tax Desk - Nik Diksic and Andrea Lepitzki (New York)
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