Tax Events in The Foreign Affiliate Life Cycle

A Comparison with
Domestic Rules
Carrie Smit, Goodmans LLP

Clara Pham, KPMG LLP
Sam Tyler, KPMG LLP
Toronto Young Practitioners Group
Tax Events in the Foreign Affiliate

Life Cycle: A Comparison with
Domestic Rules
ACQUISITIONS
 Effect on tax attributes
• Para. 95(2)(f.1)
• Surplus adjustment rule
 Para. 88(1)(d) bump
 FA dumping rules

2
Domestic Rules
Acquisition of Control – Effect on Tax Attributes

 On the AoC of a Canadian corporation:
• Taxation year-end (ss. 249(4))
• Write-down of tax cost to FMV for capital property,
depreciable capital property and eligible capital
property (para. 111(4)(c), ss. 111(5.1), ss.111(5.2))
• Elimination of capital losses and property losses, and
streaming of operating business losses (ss. 111(4), ss.
111(5))
Canadian
Buyer
Canco
3

Domestic Rules
 On the Direct Acquisition of an FA
Canadian
Buyer
FA
• No deemed taxation year-end for Canadian tax purposes

• Income, gains and losses realized by an FA after the AoC
do not generally include amounts that accrued prior to
the acquisition (para. 95(2)(f.1))
- can carve-out income and gains, as well as losses
- unlike ss. 111(4) and ss. 111(5.1), this rule does not
technically reduce tax cost to FMV
4
Domestic Rules
 Para. 95(2)(f.1) is a complicated rule based on

whether an FA was a “specified person or partnership”
(SPOP) in respect of the Canadian shareholder while
income, gain or loss accrued
• Based on whether income/gain/loss accrued while an

FA was an FA of:
(i) Canadian shareholder;
(ii) Canadian resident which deals NAL with
Canadian shareholder; or
(ii) predecessor of Canadian shareholder

5

Domestic Rules
 Canadian Buyer acquires

100% of Canco 1 and FA1
Canadian from AL seller
Buyer  ACB of shares of Canco 2 is
reduced to $80
Later sale for $110 results
in $30 capital gain
Canco 1 FA1  ACB of shares of FA2 is not
reduced to $80
ACB = $100 ACB = $100 • Later sale for $110 results
FMV = $80 FMV = $80
in $10 capital gain
Canco 2 FA2 • However, later sale for $50
only results in $30 capital
loss

6
Domestic Rules
Canadian  ACB of shares of Canco 2 is

Buyer not increased to $120 – unless
designation made under para.
111(4)(e), or para. 88(1)(d)
bump available
• Later sale for $150 results in
Canco 1 FA1 $50 capital gain
 ACB of shares of FA2 is also
ACB = $100 ACB = $100 not increased to $120, but any
FMV = $120
FMV = $120
gain accrued prior to “SPOP”
status is carved out
Canco 2 FA2 • Later sale for $150 results in
$30 capital gain

7

Domestic Rules
Foreign Foreign
Parent Parent
Canco 1 Canco 2 Forco Canco 1
Accrued Accrued
Forco
Income/Losses Income/Losses
Canco 2
(now FA)
 AoC rules do not apply to Canco 2 (para. 256(7)(a))

 Para. 95(2)(f.1) does apply to Forco

8
Domestic Rules
 On the Indirect Acquisition of an FA (through

acquisition of Canadian Target)
Canadian
Target
FA
• No taxation year-end of an FA (ss. 249(4))

• Para. 95(2)(f.1) will apply if there is an AL acquisition of
the Canadian Target, and an amalgamation or winding
up of Canadian Target (“designated acquired
corporation”)
9

Domestic Rules
Canadian  Canadian Buyer acquires all

Buyer shares of Canadian Target
and amalgamates with
Canadian Target
Canadian • Para. 95(2)(f.1) will apply to
Target FA1 and FA2
• Any income, gains or losses
will not include income,
gains or losses accrued
FA1
prior to acquisition
• Para. 95(2)(f.1) will not
apply if Canadian Target is
FA2 not amalgamated or wound
up

10
Domestic Rules
Surplus Adjustment Rule
Canadian  Regulation 5905(5.2)

Buyer  “Tax-free surplus balance” plus
tax cost of the FA shares
cannot exceed FMV of the FA
shares
Canadian  “Tax-free surplus balance” is
Target generally surplus which can be
repatriated to Canada on a tax
ACB = $20 free basis (eg. exempt surplus).
FMV = $100
 Exempt surplus of FA will be
Exempt reduced to $80
FA Surplus  Similar to ss. 111(4)
= $130

11

Domestic Rules
Paragraph 88(1)(d) Bump

 Generally, the para. 88(1)(d) bump provides an increase in
tax cost of shares of subsidiaries of Canadian Target
• Need to amalgamate Canadian Buyer and Canadian Target (or
wind-up Canadian Target)
Canadian
Buyer
ACB =$200
FMV =$200
Canadian
Target
ACB = $10 Bump = $190
FMV = $200
Canco
12
Domestic Rules
 Bump of ACB of FA shares is limited – subpara.

88(1)(d)(ii)
• Bump cannot exceed amount by which the FMV of FA

shares exceeds the ACB of the FA shares plus a
“prescribed amount”
• Prescribed amount is generally the “tax-free surplus

balance” of the FA at the time of the acquisition

13

Domestic Rules
Canadian  Bump to ACB of Canco shares

Buyer is $190 (resulting in ACB =
ACB = $500 Amalgamate FMV = $200)
FMV = $500
Canadian  Bump to ACB of FA shares is

Target only $100 (resulting in ACB =
$180, so ACB ($180) + ES
($120) = FMV ($300))
ACB = $10 ACB = $80
FMV = $200 FMV = $300
Exempt
Canco FA Surplus
= $120

14
Domestic Rules
FA Dumping Rules
 Rules apply to a corporation resident in Canada (CRIC)
that is (or becomes after the investment and as part
of the series of transactions) controlled by a non-
resident corporation
 Rules apply where CRIC makes an investment in a
non-resident corporation that is immediately after
the investment (or become as part of the series of
transactions) an FA of the CRIC
 Consequence is reduction of cross border PUC or
deemed cross border dividend

15

Domestic Rules
Foreign  Investment by Canco in FA (by

Parent share acquisition, capital
contribution, loan, etc) results
in dollar for dollar a reduction
of PUC of Canco shares or a
Canco deemed dividend to Foreign
(CRIC) Parent
 No consequence where Canco

invests in CanSub
CanSub FA

16
Domestic Rules
ONGOING OWNERSHIP
• Residency
• Distributions
 Characterization
 Taxation of dividends/surplus accounts
 Shareholder loans vs. Upstream loans
 Recharacterization rules
 GAAR vs. ss. 95(6)

17

Domestic Rules
Residency
 In domestic context, Canadian incorporated
companies deemed resident in Canada and
subject to Canadian tax on worldwide income
 Common law residency based on location of “mind and
management” has little relevance
 For FAs, to generate “exempt surplus” from
active business earnings an FA must be
“resident” in “designated treaty country”
 Residence requires common law residency and treaty
residency

18
Domestic Rules
Distributions - Characterization
 Domestic context
 Follow legal form – dividends or returns of capital
 FA context
 ss. 90(2) deems pro rata distribution in respect of
shares of a class to be a dividend
 If requirements of ss. 90(2) not satisfied, distribution
is a taxable shareholder benefit
 Certain elections available to have distributions have
same effect as a return of capital

19

Domestic Rules
Taxation of Dividends
 Domestic context
 Intercorporate dividends are generally received tax free
 Dividends do not generally trigger reductions in ACB or
gains to the shareholder
 FA context
 Depending on the surplus pool from which they are paid,
dividends can be received tax free or subject to tax with
some relief for foreign taxes paid
 Dividends from pre-acquisition surplus are received tax
free but reduce ACB and can trigger gains if ACB goes
negative
 “90-day” rule for dividends that would otherwise be paid out
of pre-acquisition surplus
20
Domestic Rules
Shareholder Loans vs. Upstream Loans

 Discourages the withdrawal of corporate profits
without incidence of Canadian tax
 Domestic Context – ss. 15(2): amount of
shareholder loan is a deemed dividend subject to
withholding tax
 Mostly turns on amount of time loan is outstanding
 FA context – ss. 90(6): amount of upstream loan
included in the income of Canadian taxpayer
 Subject to a number of other exceptions: available tax-
free surplus, ACB, amount of time loan is outstanding,
identity of debtor
21

Domestic Rules
Recharacterization Rules
 Example: Cl. 95(2)(a)(ii)(B)
 Payments must be deductible Canco
in computing FA2’s earnings
from an active business
 Deductibility determined
according to foreign rules if FA
earns active business income
FA1 Loan
FA2
 Para. 20(1)(c)
 Deductibility turns on tracing Interest
Payments
to an eligible use of amount

22
Domestic Rules
Recharacterization Rules (cont’d)

 Example: Cl. 95(2)(a)(ii)(D)
 For a loan used by FA2 to Canco
earn income from excluded
property shares of FA3
 For surplus purposes, FA2’s
interest deductions would be
determined according to
FA1 Loan
FA2
Canadian rules under para.
20(1)(c) because FA2 is a
holding company
FA3

23

Domestic Rules
Anti-Avoidance & FA Status

 Para. 95(6)(b) has similar wording to “avoidance
transaction” in the GAAR, but courts have
determined that para. 95(6)(b) is more limited in
scope - see: Lehigh FCA decision
 Targeted at situations where a taxpayer
“manipulates” FA status
 No rules with respect to recharacterizing the
transaction or series of transactions
 The FA shares are deemed not to have been acquired
or disposed of

24
Domestic Rules
REORGANIZATIONS &
DISPOSITIONS
• Rollovers and other tax-deferred exchanges
• Mergers, liquidations and dissolutions
• Dispositions of FAs

25

Domestic Rules
Rollovers
 FA rules include rollover rules that are analogous to ss. 85(1)
 Canada to FA transfer – ss. 85.1(3)
 Applies to transfer of shares of an FA (capital property) to
another FA
 Requires share consideration but “boot” possible
 Not elective
 Ss. 85.1(4) restrictions
 FA to FA transfer – para. 95(2)(c)

 Applies to transfer of FA shares (capital property) among FAs
 Requires share consideration but “boot” possible
 N/A to internal exchanges
 Gain results in FAPI even if transferred FA shares are
“excluded property”
26
Domestic Rules
Rollovers (cont’d)
 Other considerations
 No rollovers for transfers of assets or partnership interests
 Anti-avoidance rule in ss. 95(6)
 Surplus consequences
 Benefit conferral issues
 Other tax-deferred exchanges

 Sections 51 and 86 should apply in FA context
 FA is a “taxpayer”

27

Domestic Rules
FA Mergers
• FA merger rules based on there
Canco
Ss.87(4) & being a “foreign merger”
para. 95(2)(d.1) • Requirements of “foreign
merger” in ss. 87(8.1) similar
FA1 FA2 to requirements of a qualifying
amalgamation for ss. 87(1) in
domestic context.
Paras. 95(2)(d) and (d.1) • Ss. 87(4) and par. 95(2)(d)
provide rollover at shareholder
FA3 FA4 level
• Para. 95(2)(d.1) provides
rollover of FA property

28
Domestic Rules
FA Mergers (cont’d)
 Other Considerations
 Absorptive-style mergers and ss. 87(8.2) deeming
rules
 “Downstream” mergers possible
 See para. (n) of definition of disposition
 Lack of detailed continuity rules like in domestic
context
 Continuity of surplus pools
 Anti-Avoidance Rules
 Proposed ss. 87(8.3) similar in effect to ss. 85.1(4)

29

Domestic Rules
FA Liquidations and Dissolutions

Para. 95(2)(e) Liquidation and Dissolution
>= 90% ownership then “designated
liquidation and dissolution” (DLAD)
Canco  If DLAD:
• All property of liquidating FA disposed of at
“relevant cost base”
• Shares of FA2 disposed of at cost other
than if loss in the shares and shares are
FA1 excluded property
• Some limited continuity rules
If not DLAD:
• Only excluded property shares eligible for
FA2 rollover; all other FA2 properties disposed
of at FMV
• Shares of FA2 disposed of for amount equal
to disposition proceeds to FA2 (less debt
assumed)
30
Domestic Rules

 Para. 95(2)(e) Other Considerations
 No election required for DLAD
 Potential recognition of gains or losses depending on facts
 General preference for mergers?
 Surplus implications
 Automatic application of ss. 93(1.1) on dissolution if gain

31

Domestic Rules

Ss. 88(3) Liquidation and Dissolution
>= 90% ownership then “qualifying liquidation and
dissolution” (QLAD)
Canco If QLAD:
• All property of liquidating FA disposed of at
“relevant cost base”
• Shares of FA disposed of for amount equal to
FA’s proceeds of disposition
FA • Subject to “suppression election”, gain will be
realized if ACB of shares of FA is less than the
relevant cost base of its assets
If not QLAD:
• Only excluded property shares eligible for
rollover; all other FA properties disposed of at
FMV
• Shares of FA disposed of for amount equal to
disposition proceeds to FA (less debt assumed)
32
Domestic Rules

 Ss. 88(3) Other Considerations
 Must file election forms for QLAD and suppression
election – not automatic
 Cannot recognize loss on QLAD
 If gain, no deemed ss. 93(1) election that forces
repatriation of surplus balances
 Surplus implications

33

Domestic Rules
FA Dispositions – Ss. 93(1) Elections

 Akin to safe income planning in domestic context
 Capital gain otherwise realized on disposition of an
FA reduced by electing under ss. 93(1)
 Elective when vendor is Canco (ss. 93(1)) and automatic
where vendor is FA (ss. 93(1.1))
 Eligible surplus based on each relevant FA in group
notionally paying dividend equal to their “net surplus”
 Restricted by amount of dividends that would be
received if dividends were paid
 “90-day” rule not applicable for ss. 93(1)

34
Domestic Rules
Subsection 93(1) Election Example

Canco disposes of shares of FA:
Canco
Proceeds $1,000,000
ACB ($ 400,000) ACB = $400K
CG (without ss. 93(1)) $ 600,000
FA
ss. 93(1) election $ 400,000
Adjusted proceeds $ 600,000
ACB ($ 400,000) Exempt surplus =
$400K
CG $ 200,000

35

Domestic Rules
FA Dispositions – Other Considerations
 Foreign Tax Credit available in respect of gain on

sale of shares of an FA?
 Capital gain not “income from a share” of an FA
 Capital gain needs to be considered foreign source
income
 Stop loss rules and foreign exchange
 Ss. 93(2), (2.01) and related rules

36
Domestic Rules
SELECTED COMPLIANCE
CONSIDERATIONS

37

Domestic Rules
Domestic FA Context
Ss. 85(1) – elective Ss. 85.1(3) – automatic
Para. 95(2)(c) – automatic
Ss. 88(1) – automatic Ss. 88(3.1) QLAD – elective

Para. 95(2)(e) DLAD – automatic
Returns of capital – automatic Reg. 5901(2) pre-acq. surplus
decreases to PUC dividend – elective
Ss. 55(2) – automatic deemed Ss. 93(1) – elective

dividends Ss. 93(1.1) – automatic
Para. 111(4)(e) - elective Para. 95(2)(f.1) – automatic
T-106s & T-1134s

38

Tax Events in The Foreign Affiliate Life Cycle

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A Comparison with

Carrie Smit, Goodmans LLP

Tax Events in the Foreign Affiliate

Toronto Young Practitioners Group

Acquisition of Control – Effect on Tax Attributes

Tax Events in the Foreign Affiliate

 On the Direct Acquisition of an FA

• No deemed taxation year-end for Canadian tax purposes

 Para. 95(2)(f.1) is a complicated rule based on

• Based on whether income/gain/loss accrued while an

Toronto Young Practitioners Group

Tax Events in the Foreign Affiliate

 Canadian Buyer acquires

Toronto Young Practitioners Group

Canadian  ACB of shares of Canco 2 is

Toronto Young Practitioners Group

Tax Events in the Foreign Affiliate

Canco 1 Canco 2 Forco Canco 1

 AoC rules do not apply to Canco 2 (para. 256(7)(a))

Toronto Young Practitioners Group

 On the Indirect Acquisition of an FA (through

• No taxation year-end of an FA (ss. 249(4))

Tax Events in the Foreign Affiliate

Canadian  Canadian Buyer acquires all

Toronto Young Practitioners Group

Surplus Adjustment Rule

Canadian  Regulation 5905(5.2)

Toronto Young Practitioners Group

Tax Events in the Foreign Affiliate

Paragraph 88(1)(d) Bump

 Bump of ACB of FA shares is limited – subpara.

• Bump cannot exceed amount by which the FMV of FA

• Prescribed amount is generally the “tax-free surplus

Toronto Young Practitioners Group

Tax Events in the Foreign Affiliate

Canadian  Bump to ACB of Canco shares

Canadian  Bump to ACB of FA shares is

Toronto Young Practitioners Group

Toronto Young Practitioners Group

Tax Events in the Foreign Affiliate

Foreign  Investment by Canco in FA (by

 No consequence where Canco

Toronto Young Practitioners Group

Toronto Young Practitioners Group

Tax Events in the Foreign Affiliate

Toronto Young Practitioners Group

Toronto Young Practitioners Group

Tax Events in the Foreign Affiliate

Shareholder Loans vs. Upstream Loans

Tax Events in the Foreign Affiliate

Toronto Young Practitioners Group

Recharacterization Rules (cont’d)

Toronto Young Practitioners Group

Tax Events in the Foreign Affiliate

Anti-Avoidance & FA Status

Toronto Young Practitioners Group

Toronto Young Practitioners Group

Tax Events in the Foreign Affiliate