Tax Update A report on cross-border developments in Canadian tax law / September 2011

Transcription

1 1 In This Issue Foreign Affiliate Proposals Some Welcome and Unwelcome Changes... 1 Foreign Entity Characterization, Treaty Interpretation and Income Attribution... 5 New Developments in Canadian Withholding Tax Obligations New Forms Signal the End of the Address Rule... 9 A report on cross-border developments in Canadian tax law / September 2011

2 1 Foreign Affiliate Proposals Some Welcome and Unwelcome Changes By Robert W. Nearing & Gabrielle M.R. Richards On August 19, 2011, the Department of Finance (Finance) released extensive proposed amendments (2011 Proposals) to the foreign affiliate rules which, in some cases, replace a number of the more controversial amendments that were contained in the proposed amendments released on February 27, 2004 (2004 Proposals) and that may be viewed as a significant shift in tax policy. Many of the less controversial amendments contained in the 2004 Proposals, which replaced earlier proposals released in 2002, have been passed or included in other draft legislation packages. For a discussion of certain of the earlier proposals, see dated January 22, In the release accompanying the 2011 Proposals, Finance referred to the recommendation of the Advisory Panel on Canada s System of International Taxation (Advisory Panel) in December 2008 that changes be made to Canada s system of taxation to extend the exemption system to all active business income, regardless of the source country. If the recommendation were adopted, the system would be greatly simplified since there would be no need for the concept of taxable surplus. Finance expressly rejected this recommendation on the basis that access to exempt surplus treatment is being used as an incentive to encourage countries to enter into Tax Information Exchange Agreements (TIEAs) with Canada. TIEAs are a current priority of the Government. What follows is a brief overview of selected amendments contained in the 2011 Proposals. The topics discussed include the new upstream loan rule, the new hybrid surplus rules, the new anti-avoidance rule with respect to surplus reclassification, the new return of capital regime with respect to foreign affiliates, amendments to the reorganization rules, the tightening of the foreign accrual property income (FAPI) regime with respect to FAPI capital losses, changes to the rules with respect to the calculation of a foreign affiliate s earnings and changes to foreign exchange gains and losses. Finance is accepting comments on the 2011 Proposals until October 19, It remains to be seen whether these proposals are the last word on changes to the foreign affiliate rules. Canadian taxpayers who relied on earlier proposals in their tax planning will need to consider whether the 2011 Proposals give rise to adverse or beneficial treatment. Upstream Loans In what can only be viewed as a significant tax policy shift from the provisions of the Income Tax Act (Canada) (Act) and their application by the Canada Revenue Agency in published tax rulings, the 2011 Proposals contain a new upstream loan rule. This rule is modelled on existing subsection 15(2) of the Act (domestic shareholder loan rule). Under the upstream loan rule, Canadian taxpayers will be required to include in their income the amount of loans made by their foreign affiliates to them and to certain non-arm s length persons (other than controlled foreign affiliates of the taxpayers). Like the domestic shareholder loan rule, there are exceptions for indebtedness repaid within two years of the date the indebtedness arose, provided the repayment is not part of a series of loans or other transactions and repayments, and for indebtedness arising in the ordinary course of business of the creditor. The income inclusion arising under the new upstream loan rule may be offset by any exempt surplus or taxable surplus with sufficient underlying tax on hand. This concession appears to have been made to allow taxpayers to avoid foreign withholding tax that might otherwise arise if the foreign affiliate pays a dividend. Interestingly, no such deduction is available in respect of pre-acquisition surplus.

3 2 The upstream loan rule was introduced as an anti-avoidance rule to prevent taxpayers from making synthetic dividend distributions from foreign affiliates in order to avoid what would otherwise be income inclusions that are not fully offset by the deductions referred to above. The explanatory notes state that the rule was needed to protect the integrity of the existing taxable surplus and the new hybrid surplus regimes. Attempts to get around the rule will be subject to review under the general anti-avoidance rule (GAAR). In particular, back-to-back loans with arm s length persons would be considered a misuse of the rule and an abuse of the Act as a whole for the purposes of the GAAR. The upstream loan rule generally applies to taxation years that begin after August 19, There is no grandfathering in respect of existing indebtedness but indebtedness in existence prior to August 19, 2011, is deemed to have come into existence on August 19, 2011, so that a taxpayer can rely on the two-year repayment window referred to above before being subject to the new rule. Hybrid Surplus As noted above, the Advisory Panel s recommendation that Canada extend the current exemption system to all active business income earned by foreign affiliates would have resulted in the repeal of the taxable surplus regime. Instead, the 2011 Proposals create a new surplus account known as hybrid surplus. Hybrid surplus is a hybrid of exempt and taxable surplus in that one-half of any distributions from hybrid surplus will be treated as exempt and the other half will be treated as taxable, with allowance for a deduction reflecting grossed-up underlying foreign taxes. Hybrid surplus will generally include 100 per cent of any gains from the sale of shares of a foreign affiliate by another foreign affiliate, other than FAPI gains. Presently, these gains are divided evenly between exempt and taxable surplus, which allows for the repatriation of exempt surplus in advance of taxable surplus, which can be beneficial where there is no or little underlying foreign tax in respect of the taxable surplus. As noted below, the gains suspension rule previously contained in the 2004 Proposals has been replaced with the surplus reclassification rule. Hybrid surplus will arise on internal dispositions occurring after August 19, 2011, and with respect to all other dispositions, after Surplus Reclassification The 2011 Proposals also contain a new anti-avoidance rule that reclassifies certain amounts from exempt to taxable surplus where the amounts arise from transactions that are avoidance transactions, within the meaning of the GAAR (i.e., a transaction that cannot reasonably be considered to have been undertaken or arranged for bona fide purposes other than to increase the exempt earnings or decrease an exempt loss). This rule replaces the gains suspension regime introduced in the 2004 Proposals, which was intended to apply to internal transfers of property. Interestingly, although the surplus reclassification rule is based on the GAAR, it does not contain an exemption for transactions that do not result in a misuse or an abuse of the Act. Consequently, it would seem that this new anti-avoidance rule will have a much broader application than the GAAR. This new anti-avoidance rule will apply to transactions entered into after August 19, Returns of Capital In a welcome change, the 2011 Proposals abandoned the foreign affiliate paid-up capital (FPUC) rule introduced in the 2004 Proposals and refined in subsequent comfort letters, in favour of a simplified regime. Instead, all distributions received on shares of a foreign affiliate will generally be considered dividends notwithstanding their legal form as capital or other amount. Recipients of such distributions will be able to treat the dividends as having been paid from pre-acquisition surplus and will thus be entitled to a deduction under paragraph 113(1)(d) of the Act. Pre-acquisition surplus dividends reduce

4 3 the taxpayer s adjusted cost base in its foreign affiliate shares, thus allowing the taxpayer to access its cost base in its shares of a foreign affiliate, as a surrogate for FPUC. Where such an election results in the taxpayer realizing a capital gain because its cost base in the shares of the foreign affiliate is reduced to a negative amount, the taxpayer will be required to treat all or a portion of the capital gain as a dividend paid out of exempt, hybrid or taxable surplus. These rules generally apply to dividends paid after August 19, However, a taxpayer may elect to have these rules apply to dividends paid after February 27, 2004, by all foreign affiliates in its corporate group. Foreign Affiliate Reorganizations The 2011 Proposals amend various provisions of the Act that deal with liquidations and dissolutions of foreign affiliates, mergers or combinations of foreign affiliates and certain share-for-share exchanges. With respect to liquidations, the 2011 Proposals contains two sets of rules, one that applies to a liquidation of a foreign affiliate into a Canadian shareholder and one that applies to a liquidation of a foreign affiliate into another foreign affiliate. Both rules have been simplified and are welcome changes. The 2004 Proposals with respect to the liquidation of a top-tier foreign affiliate will now apply to all properties received by the Canadian parent corporation on the liquidation and allow for a rollover of all properties, rather than just shares of another foreign affiliate, where certain conditions are met. Essentially, this rule will now mirror the requirements and results of the tax deferred liquidation rules with respect to Canadian corporations. A second set of rules applies a similar tax-deferred treatment where the requisite ownership requirements are met (at least a 90 per cent surplus entitlement percentage or other conditions are satisfied). If none of the conditions are satisfied, the liquidation will be a taxable event. The first set of rules generally applies to liquidations that begin after February 27, 2004, while the second set of rules generally applies to liquidations that begin after August 19, The 2011 Proposals with respect to foreign mergers remove the 90 per cent surplus entitlement percentage requirement and the foreign tax law non-recognition requirement as pre-conditions to the application of the broad rollover rule. Further, the rollover will now apply to all property, not just capital property. The 2011 Proposals contain a so-called absorptive merger rule which will extend the beneficial treatment associated with qualifying foreign mergers to absorptive style mergers where one of the predecessor corporations is the survivor to the amalgamation (common in U.S. amalgamations). These amendments generally apply to mergers or combinations that occur after August 19, However, taxpayers may elect to have the amendments apply to mergers or combinations that occur after December 20, Lastly, the tax deferred share-for-share rollover rule is being amended so that it will no longer apply where the shares being transferred have an inherent loss. The loss will be suspended and released only in certain circumstances. These amendments apply to dispositions that occur after August 19, FAPI Capital Losses The 2011 Proposals will amend the definition of FAPI so that the allowable portion of capital losses of a foreign affiliate from dispositions of non-excluded property will no longer be deductible against ordinary FAPI income. As in the domestic context, FAPI capital losses will only be deductible against FAPI capital gains with any unapplied FAPI capital losses being carried forward for 20 years and carried back three years. This amendment will generally be effective for taxation years of foreign affiliates that end after August 19, 2011, with certain of these amendments applying to dispositions that occur after February 27, Transitional rules also exist with respect to dispositions occurring in taxation years of a foreign affiliate that end on or before August 19, 2011.

5 4 Earnings Calculations In our dated March 8, 2011 we commented on a foreign affiliate s calculations of its earnings where it is not required to compute its income or profits under the taxation laws of its country of residence or the country in which it carries on its active business. In such circumstances a foreign affiliate is required to compute its earnings under Canadian rules. This provided for a planning opportunity in that a foreign affiliate could choose not to take discretionary deductions such as capital cost allowance in computing its earnings, thus maximizing its exempt surplus. The 2011 Proposals have put an end to such planning by introducing a rule which requires the maximum amount of any discretionary deductions to be claimed in computing the earnings of a foreign affiliate who is required to compute such earnings under Canadian income tax rules. This new amendment will apply to taxation years of a foreign affiliate that end after August 19, Foreign Currency Debts In addition to various amendments to the rules on the computation of income, gains or losses, the 2011 Proposals amend the rule in subsection 39(2) of the Act, which currently applies where a taxpayer makes a gain or sustains a loss from foreign currency fluctuations, to restrict its application to foreign currency debt owing by a taxpayer. Thus, foreign exchange gains or losses in respect of dispositions of property, including dispositions of foreign currency, will now be determined under subsection 39(1) and there will not be any rule permitting a corporation to recognize foreign exchange gains made, or losses sustained, in respect of its own shares, such as on a redemption of foreign currency denominated shares. This amendment generally applies to taxation years that begin after August 19, 2011, except that in the case of a foreign affiliate, it applies to taxation years that end after August 19, 2011.

6 5 Foreign Entity Characterization, Treaty Interpretation and Income Attribution By Christopher Falk & Stefanie Morand A recent Tax Court of Canada decision makes a number of determinations that are very significant in both a Canadian domestic and international tax context. These determinations touch upon the ability of parties to rectify retroactively a deficient contract, whether certain income attribution rules are triggered on a fair market value sale to a trust, the approach to foreign entity characterization, and the application of a tax treaty to prevent Canada from taxing a Canadian gain attributed to a resident of Canada pursuant to the Income Tax Act (Canada) (Act). Some of the decisions reached by the Court and the Court s approach to some of the issues were unexpected and, if upheld on appeal and followed in future decisions, will be significant in a broad range of circumstances. In Sommerer v. The Queen, 2011 DTC 1162, [2011] 4 CTC 2068 (TCC), Mr. Justice Miller dealt with a Canadian resident taxpayer (Mr. Sommerer) who had been assessed by the Minister of National Revenue (Minister) in respect of a substantial capital gain arising on the sale by an Austrian foundation (i.e., a Privatstiftung) of shares of two Canadian corporations. Simplified, in 1996, Mr. Sommerer s father, a resident of Austria and a non-resident of Canada, used his own funds to establish the foundation for the benefit of Mr. Sommerer and others. The foundation was managed by an executive board comprised of three unrelated Austrian residents and guided by an advisory board of which Mr. Sommerer was a member. Coincident with the foundation s establishment, the foundation purported to purchase from Mr. Sommerer shares that were subsequently sold by the foundation at a gain. Originally, the Minister reassessed Mr. Sommerer on the basis that subsection 75(2) of the Act applied to attribute to Mr. Sommerer the gain on the foundation s sale of the shares. Subsection 75(2) is a provision that, in general terms, attributes income and gains earned by a reversionary trust back to the person from whom the property, or substituted property, was received. In the Reply to the Notice of Appeal, the Minister adopted as a new primary position the argument that Mr. Sommerer did not sell certain of the shares to the foundation until shortly before the third-party sale and that Mr. Sommerer realized a gain at that time on the basis of a non-arm s length disposition deemed under the Act to occur at fair market value (i.e., the price paid by the third-party which was substantially in excess of the fair market value of the shares in 1996). The issues considered by the Court were as follows: 1. Whether the shares were sold by Mr. Sommerer to the foundation in 1996, as maintained by Mr. Sommerer, or 1998, as maintained by the Minister; 2. Whether the arrangement whereby the taxpayer s father endowed the foundation with funds for the purpose set forth in the foundation deeds could be viewed as a trust for Canadian income tax purposes; 3. If a trust existed, whether subsection 75(2) applied to attribute to Mr. Sommerer the gain on the disposition of the shares by the foundation;

7 6 4. If a trust existed and subsection 75(2) applied, whether the provisions of the Canada-Austria Income Tax Convention (Treaty) prevented Canada from taxing the capital gain realized by the foundation on the disposition of the shares; and 5. Whether the foundation was Mr. Sommerer s agent for the purpose of disposing of the shares. In this article, we comment on the Court s conclusions that a trust existed and that subsection 75(2) did not apply on the basis that the person in subsection 75(2) does not include a fair market value vendor such as Mr. Sommerer. We also comment on the Court s conclusion that even if subsection 75(2) applied, Article XIII(5) of the Treaty precluded Canada from taxing Mr. Sommerer on the gain. In respect of the other issues addressed in the decision, we note that: (i) the Court determined that the sale by Mr. Sommerer to the foundation occurred in 1996 and, in reaching that conclusion, the Court gave effect retroactively to an amending agreement that Mr. Sommerer and the foundation entered into after 1996 fixing some deficiencies in the initial agreement between the parties; and (ii) the Court determined that the foundation was not Mr. Sommerer s agent for the purpose of disposing of the shares. Foreign Entity Characterization While the Canada Revenue Agency (CRA) has historically taken the position that an entity with separate legal identity and existence should be regarded as a corporation for Canadian income tax purposes, the CRA abandoned this position in 2008 in favour of a new two-step approach wherein (i) the characteristics of the foreign arrangement are determined under the foreign legislation, and (ii) those characteristics are compared with those of recognized categories under Canadian law so as to classify the foreign arrangement under one of those categories, notwithstanding that the foreign arrangement might lack some of the fundamental characteristics of the particular category. Applying this approach, the Minister concluded that the foundation was a trust while Mr. Sommerer argued that it was a corporation. Choosing to reframe the issue, the Court stated as follows: [B]oth parties framed this issue as whether the [foundation] was a corporation or a trust. I suggest this is an inappropriate way of framing it. The [foundation] is a separate legal entity: a trust under Canadian law is not; it is a relationship describing how property is held. The [foundation] could be a trustee. The question is simply whether a trust existed, not whether the [foundation] is a trust or corporation. Later, in respect of this issue, the Court stated that: This should not be an issue of whether an Austrian Private Foundation under the Austrian Private Foundation Act (APFA) is a trust, let alone whether the [foundation] is a trust. That is the wrong question. The appellant says it is a company; the Respondent says it is a trust. I have concluded that, depending on the terms of the Foundation Declaration and Supplemental Declaration, an Austrian Private Foundation could be considered a trust company, acting as trustee, and with respect to the [foundation], I find that that is as good a label as can be attached, when looking at it through the eyes of Canadian laws. What needs to be analyzed, however, is not what the [foundation] is, but what relationship exists amongst the [foundation] (a separate legal person), Mr. Hebert Sommerer, and Mr. Peter Sommerer and the Sommerer family. Is there a trust relationship? Can Mr. Hebert Sommerer be seen as a settlor? Can the [foundation] be seen as a trustee, perhaps a corporate trustee? Can Mr. Sommerer be seen as a beneficiary? Do the three certainties, certainty of intention, certainty of subject matter, and certainty of objects exist? Are there any other characteristics of the Canadian trust that are missing in the Sommerer arrangement?

8 7 Having thus reframed the issue, the Court found that a trust relationship existed between Mr. Herbert Sommerer (i.e., Mr. Sommerer s father, as settlor), the foundation (as trustee) and Mr. Sommerer and others (as beneficiaries). Interestingly, while the Court acknowledged the importance of the three certainties (namely, certainty of objects, subject matter, and intention), its analysis did not hinge on them. Rather, the essential ingredients of a trust under Canadian law identified and addressed by the Court were (i) segregated property, (ii) owned by a person (a trustee) having control of the property, (iii) for the benefit of persons (beneficiaries), and (iv) to whom the trustee has a fiduciary duty enforceable by the beneficiaries. As stated by the Court: If I find these essential features in the arrangement by which the [foundation] held [the shares], then I will have no difficulty finding the three certainties were met to create the trust. It is absolutely clear to me that there is certainty of subject matter and objects, and if the essential features of a trust are evident, then the intention of Mr. Herbert Sommerer to create a trust can be gleaned from the Foundation Declaration and the application of the APFA. In respect of the Court s approach to this issue, it is, of course, quite possible for a foreign entity that is a corporation to act as a trustee in respect of property that is owned by the foreign entity but held for the benefit of others. What is noteworthy is that in reaching its conclusion on whether there was a trust, the Court rejected the entity-characterization approach that had been advocated by both parties, and that has been widely used in the tax community, whereby the relevant legislation and governing documents are assessed in determining whether the entity should be considered to be a trust or a corporation for purposes of the Act. Here, the Court reached the conclusion that the very legislation and governing documents that created the foundation (a legal entity akin to a trust company) also made the foundation a trustee (i.e., the Court did not find that there was a trust agreement, written or unwritten, separate from the entity s constating documents). This approach, if upheld on appeal and adopted in future decisions, may well prompt the CRA to revisit situations in which it has previously agreed that a foreign entity was not a trust. Where a foreign trust is not intended to be created, the approach should also prompt practitioners to proceed with great care, including clarifying that the foreign entity owns its property for its own benefit rather than for the benefit of third-parties and that any such third-parties are not owed fiduciary duties and have no rights of enforcement. Subsection 75(2) the Person Having concluded that a trust existed, the Court considered whether subsection 75(2) applied to attribute to Mr. Sommerer the gain on the disposition of the shares by the foundation. The Court concluded that the provision did not apply on the basis that the person contemplated in subparagraph 75(2)(a)(i) did not include a fair market value vendor such as the taxpayer. More particularly, the Court reasoned as follows: The nature of the trust, and whether it is of a type contemplated by subsection 75(2) [ ], is to be discerned at the time of creation. On the creation of the trust by a settlor, there can only be one person from whom property is received the settlor. There is no other person. This does not however preclude the possibility of another person settling property in trust with the same trustee and on the same terms, but in such a case, I would suggest there is another trust created. In effect, by the opening words of subsection 75(2) [ ] only a settlor, or a contributor akin to a settlor is contemplated as being the defined person. The narrow interpretation adopted by the Court is welcome given that there has long been a significant concern that, based on its wording, subsection 75(2) may extend to fair market value sales. Further, this interpretation is welcome as subsection 75(2) is an awkwardly worded anti-avoidance provision that,

9 8 given the absence of a purpose requirement and the broad drafting of the provision, can be triggered inadvertently. Once subsection 75(2) has been triggered, the consequences can be extremely harsh (i.e., not only attribution of income and gains, but also an inability of the trust to distribute property to most beneficiaries on a tax-deferred basis). In some cases, the consequences can be impossible to rectify notwithstanding that there may have been no mischief. Most, if not all, practitioners would likely agree that there is no policy rationale for applying subsection 75(2) to a fair market value vendor. However, the Court s conclusion that a textual read of the provision supports the conclusion that only the settlor (or a subsequent contributor who could be seen as a settlor) can be the person for purposes of subsection 75(2) is less obvious, at least in the view of the authors. Since the Court s reasoning on this point is somewhat difficult to follow and given the limited amount of subsection 75(2) jurisprudence, it will be very interesting to see whether, on appeal, the Federal Court of Appeal agrees with the conclusion. Treaty Interpretation The Court also concluded that if, contrary to its earlier conclusion, subsection 75(2) applied to attribute the foundation s gains to Mr. Sommerer, the provisions of the Treaty would nonetheless prevent Canada from taxing the capital gains realized by the foundation. More particularly, the Court held that Article XIII(5) of the Treaty (being the general gains provision) overrode subsection 75(2) and that if the drafters of the Treaty had intended otherwise, they could have included a provision to that effect. While the Minister sought to rely on the 2003 OECD Commentary which provides that domestic anti-avoidance rules like substance over form, economic substance and the GAAR are part of the basic domestic rules set by domestic tax laws and are not addressed in tax treaties and [ ] therefore, not affected by them, the Court followed the Federal Court of Appeal in Prevost (2009 D.T.C. 5053) and stated that a later OECD Commentary (such as the 2003 OECD Commentary in the case at issue) should only be of assistance if not in conflict with the Commentary in existence at the time the relevant treaty was entered into. As the Court found that the 2003 OECD Commentary and the 1997 OECD Commentary were very much in conflict, the Court restricted its analysis to the latter. That Commentary suggests that if a state intended that a domestic anti-avoidance provision remain applicable in the treaty context, it would have to incorporate it into the treaty. In commenting on this case generally, the Court noted that: It is not surprising the Government would be interested in Mr. Sommerer s activities, for, as acknowledged by the Appellant, had Mr. Herbert Sommerer revoked the Foundation shortly after the sale of the Vienna shares and distributed the funds to Mr. Sommerer and his wife, there would have been no tax payable by the Sommerers in Canada, if the distribution was considered to be from a non-resident trust. And indeed, I have found that the [foundation] was a trustee of a non-resident trust, but not a trust captured by the wording of subsection 75(2) of the Act. [ ] I have concluded subsection 75(2) of the Act does not apply to a beneficiary vendor of property at fair market value to a trust, but only to a settlor or subsequent contributor, who could be seen as a settlor. If this is an incorrect reading of subsection 75(2) of the Act, and it is meant to apply to beneficiaries such as Mr. Sommerer, then I find the Convention overrides that application in Mr. Sommerer s case. Not surprisingly given the planning opportunities that may be available if the Court s conclusions on subsection 75(2) are correct, the Minister has appealed the decision to the Federal Court of Appeal on the basis that that the Court erred in (i) failing to find as a matter of law that, on a proper textual, contextual and purposive construction of subsection 75(2), any person who transfers property to a trust, whether by way of settlement or sale, falls within the purview of subsection 75(2), and (ii) finding that, as a matter of law, Article XIII(5) precludes the applicability of subsection 75(2).

10 9 New Developments in Canadian Withholding Tax Obligations New Forms Signal the End of the Address Rule By Nigel Johnston Earlier this year, the Canada Revenue Agency (CRA) issued new forms that can be used by persons paying amounts to non-residents that are subject to Canadian withholding taxes. Use of the forms is not mandatory and, if the only development were the release of the forms, there would be little to remark upon. However, the CRA also announced the end of the address rule used by Canadian payers in determining their withholding obligations effective December 31, 2011 and new diligence requirements. This note considers Canada s existing withholding regime, the proposed changes and the difficulties that Canadian payers will face in complying with these rules. The Income Tax Act (Canada) (ITA) imposes a 25 per cent tax on certain payments made by Canadian residents to non-residents including interest, dividends, royalties and rents (referred to as Part XIII tax). In addition, a non-resident that disposes of taxable Canadian property is liable to tax under the ITA on any income or gain arising on the disposition and may be required to obtain a clearance certificate from the CRA under section 116 of the ITA (a section 116 certificate) by paying an amount on account of the non-resident s tax liability. Recent amendments to the ITA have narrowed the scope of payments subject to Part XIII tax by excluding interest paid to an arm s length person, where the interest is not participating debt interest. In addition, the definition of taxable Canadian property has been narrowed including to exclude shares of a Canadian private company unless more than 50 per cent of the fair market of the shares was derived, directly or indirectly, from Canadian real property, resource property of timber property at any time in the preceding 60-month period. As these taxes are imposed on non-residents, Canada imposes a withholding obligation. In the case of a person paying an amount subject to Part XIII tax, the payer is required to withhold the tax and remit it to the Receiver-General. If an agent for the non-resident receives an amount from which Part XIII tax should have been withheld without the withholding having been made, the agent is liable to make the withholding and remittance. A person who has failed to withhold Part XIII tax as required is liable to pay as tax on account of the non-resident the amount that should have been withheld (and is entitled to recover from the non-resident). A reporting obligation is imposed on persons paying amounts subject to Part XIII tax. In the case of taxable Canadian property, if a section 116 certificate is not delivered where required, the purchaser of the property is liable to pay 25 per cent of the purchase price on account of the nonresident vendor s tax liability (and is entitled to recover from the vendor) unless the purchaser, after reasonable inquiry, had no reason to believe the vendor was not resident in Canada. It is noteworthy that a reasonable inquiry defence is expressly provided in the context of a section 116 certificate but not in the context of Part XIII tax. For the purposes of this note, it is assumed that a reasonable inquiry defence is not available for Part XIII tax but the point has not been definitively established by the Courts. Penalties may be assessed against a payer where an amount is not withheld as required and interest is payable at a prescribed rate from the date amount should have been withheld to date of payment to the Receiver-General. The ITA contains certain fairness provisions under which the Minister of National Revenue may waive or cancel all or part of a penalty or interest payable, but not an amount payable as tax. The provisions of a bilateral tax treaty between Canada and another country may limit Canada s ability to impose taxes on a person who is a resident of the other country for the purposes of the treaty. The treaty may require, as a condition of relief, that the recipient be the beneficial owner of the payment

11 10 (in the case of interest, dividends and royalties) and, in the case of the Canada-United States tax treaty, satisfy a limitation on benefits provision. As a matter of administrative practice, Canada allows relief at source on payments otherwise subject to the 25 per cent Part XIII tax so that the payer may apply a lower rate of withholding. However, if a non-resident disposes of taxable Canadian property in respect of which a section 116 certificate is required, the non-resident must ordinarily apply for the certificate even if the gain is exempt from tax under the treaty although the CRA may issue the certificate without requiring any payment on the basis of the treaty exemption. From the foregoing, it is apparent that a person making a payment that may be subject to Part XIII tax must determine if the recipient is a non-resident and, if so, is entitled to treaty benefits. Historically, the CRA relied on the so-called address rule under which the payer could accept the name and address of the payee as being that of the beneficial owner unless there is reasonable cause to suspect otherwise. The CRA provided a non-exhaustive list of circumstances that would give reasonable cause to question the beneficial owner: the payee is known to act, even occasionally, as an agent or nominee; the payee is reported in care of another person or in trust ; or the mailing address provided for payment of interest or dividends is different from the registered address of the owner. The CRA permitted a financial intermediary located in a foreign country to apply the benefit of tax treaties between Canada and the beneficial owners residence countries on a pooled basis if the foreign intermediary certified beneficial ownership and country of residence to the CRA. Of interest, special rules apply in the case of payments to Swiss nominees the Canada-Switzerland treaty rate can be withheld by a Canadian payer because if the beneficial owner is a resident of a third country, the nominee makes the additional withholding which is in turn paid to Canada through an arrangement with the Swiss government. These policies were set out in Information Circular IC 76-12R6, Applicable Rate of Part XIII Tax on Amounts Paid or Credited to Persons in Countries with which Canada has a Tax Convention. However, the CRA did not exonerate a payer that followed the procedures set forth in the Circular but failed to withhold the correct amount. Rather, the Circular states that the payer is liable for any deficiency in the amount of tax that should have been withheld, penalties and interest. Earlier this year, the CRA released three new forms that may be used to establish the identity of the beneficial owner of a payment. The base form is Form NR301 Declaration of Eligibility for Benefits under a tax treaty for a Non-Resident Taxpayer. The other forms are Form NR302 Declaration of Eligibility for Benefits under a tax treaty for a Partnership with Non-Resident Partners and Form NR303 Declaration of Eligibility for Benefits under a tax treaty for a Hybrid Entity. Form NR302 and Form NR303 are to be used by a partnership or hybrid entity (currently only relevant in the case of the Canada-United States tax treaty) to claim relief on some or all of a payment to be made by it based on the treaty eligibility of its partners or its members which would be established, in turn, through the provision of Form NR301 by each such partner or member. Form NR301 requires that the payee completing the form provide information including its legal status, country of residence and the nature of payments to be received. The payee must certify that the information is true and correct, that the payee is the beneficial owner of the relevant payment and that, to the best of the its knowledge and based on the factual circumstances, it is entitled to the benefits of the relevant treaty on the relevant income (which implicitly takes into account the limitation on benefits rule in the Canada-United States tax treaty in the case of a resident of the United States). A completed form will expire on the earlier of a change in eligibility for treaty benefits, and three years from the year the form is signed and date. The form is delivered to the payer in the case of a payment subject to Part XIII tax. In the case of an application for a section 116 certificate, the form would be delivered to CRA along with the application. In the case of a partnership or hybrid entity, Forms NR302 or NR303 would also be used, as applicable, when applying for a waiver of withholding under Regulation 105 to the ITA in respect of fees, commissions and other amounts in respect of services performed by a non-resident in Canada. If the only development were the release of the forms, there would be little to remark upon.

12 11 However, the CRA also released additional guidance with respect to the forms in More Information on Forms NR301, NR302 and NR303 (April 19, 2011) and Pending Update to IC Related to Forms NR301, NR302 and NR303 (May 6, 2011). In the latter document, CRA announced a fundamental change to its previous policy and the end of the address rule effective as at the end of The CRA stated: The payer must have recent and sufficient information to establish the identity of the beneficial owner for the purpose of the application of treaty benefits; whether they are resident in a particular country with which Canada has a tax treaty and whether they are eligible for treaty benefits under the tax treaty on the income being paid. While forms NR301, NR302, and NR303 are not prescribed forms, the information they request is important for determining whether a tax treaty rate can be applied. Equivalent information can be accepted. This represents a change from the Canada Revenue Agency s previous position that generally accepted the use of the payee s name and address for determining whether to apply treaty benefits. There will be a transition period until December 31, 2011, to allow payers to gather any additional information needed. In addition, in More Information on Forms NR301, NR302 and NR303, the CRA establishes a diligence requirement: The payer should review the information provided by a non-resident on Form NR301, NR302, or NR303, or in another format, to make sure they have enough information to support that the non-resident is eligible for tax convention/treaty benefits on the income being paid. To establish a withholding tax rate, the payer should question the information given and look at other information received from the non-resident, or known about the non-resident, if the payer knows or has reasonable cause to believe that the information on the form: is not correct or is misleading; contradicts information in the payer s files; or is given without knowledge or consideration of the facts of a situation. Readers may note some similarities with the rules applicable to a qualified intermediary for U.S. tax purposes. Various industry organizations are expected to make submissions that the January 1, 2012 implementation date is too soon. Even if a payer elected not to obtain new forms from recipients of payments, it would still have to ensure that it has enough information to support that a non-resident payee is eligible for treaty benefits. It is not clear how a payer is to satisfy the requirement that the information given does not contradict other information in its files does the reference to files mean all files, including paper files, or is it limited to electronically searchable files? In addition, payers such as financial intermediaries will have to put in place new account opening procedures to obtain the necessary information from payees on a going forward basis. Industry submissions are expected to point out that the new CRA guidance does not expressly state that relief would be given under the fairness provisions from the imposition of a penalty and interest if a payer fails to withhold the correct amount but obtained the necessary form and performed appropriate due diligence.

13 12 There are a number of exceptions to the proposed changes including: a. Payments made to CDS Clearing and Depository Services Inc. (CDS) on securities registered in the name of Cede & Co. are to be made without withholding tax as tax is to be withheld by CDS based on information received from the Depository Trust Company (DTC) and collected by DTC s participants. b. Reduced withholding tax may be applied by a payer without obtaining the forms or equivalent information regarding beneficial ownership, country of residence, and eligibility for treaty benefits if all of the following are true: i. The payer knows that the payee is an individual, or the payee is an estate and the trustee has an address in the United States. ii. The payer has a complete permanent address on file that is not a post office box or care-of address. ii. The payer has no contradictory information. iv. The payer has no reason to suspect the information is inaccurate or misleading. v. The payer has procedures in place so that changes in the payee s information (for example, a change of address or contact information that includes a change in country, or returned mail) will result in a review of the withholding tax rate. c. The arrangements with Swiss nominees referred to above continue. In addition, foreign intermediaries may continue to claim relief on a pooled basis on certifying that the income from specified property registered in its name is and will continue to be held solely for the beneficial ownership of persons resident and eligible to claim tax treaty benefits under a tax treaty that provides for a specified Canadian withholding tax rate on amounts paid or credited in respect of such property. In summary, payers of amounts subject to Canadian withholding tax are expected by CRA to do more in determining the residential status and entitlement to treaty benefits of payees. These changes are directed primarily at Canadian payers to ensure that the benefits of Canadian tax treaties are given only to non-residents that are entitled to them. The new forms are intended to assist payers in so doing, however, payers need to remain vigilant as a completed form provides no protection if incorrect. It is likely that significant changes will be required to the procedures and systems of financial institutions to comply with these changes. These changes are not unique but are part of a wider trend to enhanced tax withholding and reporting. The Treaty Relief and Compliance Enhancement (TRACE) project of the Organisation for Economic Co-operation and Development, for example, contemplates a system in which financial intermediaries will enter into agreements with source states to become authorized intermediaries. An authorized intermediary will collect a standardized investor self-declaration from investors relating to the investors residence and entitlements to treaty benefits. The authorized intermediary will be expected to perform certain due diligence in order to rely on an investor self-declaration. Authorized intermediaries will report payments and withholdings to the relevant source state. The TRACE proposals contemplate that a source state will exchange information with residence countries pursuant to exchange of information provisions in tax treaties to ensure that the amounts are being reported by investors in their residence countries.

14 13 The Foreign Account Tax Compliance Act (FATCA) regime to be implemented in the United States approaches the issue somewhat differently by requiring foreign financial institutions to report to the United States government with respect to accountholders that are U.S. persons and imposing a 30 per cent withholding requirement in respect of accounts of recalcitrant investors (i.e., if the institution cannot determine where or not the investor is a U.S. person). For details, see our March issue of the. Every effort has been made to ensure the accuracy of this publication, but the comments are necessarily of a general nature, are for information purposes only and do not constitute legal advice in any manner whatsoever. Clients are urged to seek specific advice on matters of concern and not rely solely on the text of this publication.

15 14 Key Contacts in Our Tax Group National Practice Group Leader and Ontario Regional Contact Douglas Cannon British Columbia Rosemarie Wertschek, QC Alberta Doug S. Ewens, QC Québec Frédéric Harvey