Foreign Affiliate Dumping December 1, 2013

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1 Purpose This Quick Update Report is intended to assist the reader in understanding Canada s socalled foreign affiliate dumping (FAD) rules. The Beginning 2007 Expert Panel: Debt Dumping In the 2007 federal Budget, the Canadian government announced it would strike an independent (i.e., non government) panel of experts (the Panel) to review Canada's system of international taxation. The Panel's mandate was to make recommendations for an international tax policy framework, specifically with respect to cross border investment: i.e., Canadian businesses investing abroad (outbound) as well as foreign businesses investing into Canada (inbound). In December of 2008, the Panel released a comprehensive report, offering many constructive and forward looking recommendations. However, one of the Panel s recommendations dealt with a perceived abuse of the existing system labeled as debtdumping. This was described as foreign owned Canadian companies borrowing funds and using those borrowed funds to acquire shares in a related foreign corporation in the group. In broad terms, the perceived abuse arose from the Canadian company s ability to deduct interest on the borrowed funds and thereby reducing its Canadian source income while at the same time being able to earn tax free dividends from the foreign corporation s active business income (exempt surplus). The Panel recommended that rules be introduced to curtail this practice, while at the same time ensuring bona fide business transactions are not affected. In the 2012 federal budget, Canadian government seized on this recommendation but also amplified it significantly. Implementation and Escalation 2012 Federal Budget The debt dumping transactions identified by the Panel were re framed in the 2012 federal Budget as foreign affiliate dumping transactions. The classic example was the transaction identified by the Panel: a Canadian subsidiary using borrowed funds to acquire shares of a foreign affiliate from its foreign parent corporation. Interest paid by Page 1 of 44

2 the Canadian subsidiary on such borrowed money would be deductible while, at the same time, most dividends received by the Canadian subsidiary on the shares of the foreign affiliate would be exempt from taxation (under Canada s exemption system for foreign active business earned in treaty countries). The Canadian government agreed this represented an erosion of the Canadian corporate tax base. It was further thought that thin capitalization rules did not provide adequate protection against these transactions. The government, however, went further to describe variations of these transactions, including the following: the acquisition of shares of a foreign affiliate using internally generated funds of the Canadian subsidiary; the acquisition of newly issued shares of an existing foreign affiliate, whether financed with internal or borrowed funds, where previously issued shares of the foreign affiliate were owned by the foreign parent or another non resident member of the same corporate group; the acquisition of foreign affiliate shares from a foreign subsidiary of the foreign parent; and the acquisition of foreign affiliate shares from an arm's length party at the request of the foreign parent. Such transactions were seen as a way for the foreign parent corporation to effectively extract earnings from their Canadian subsidiaries free of Canadian dividend withholding tax (WHT). The 2012 Budget proposed that, where certain conditions were met, a dividend would be deemed to be paid by a Canadian subsidiary to its foreign parent to the extent of any consideration given by the Canadian subsidiary for the acquisition of shares of a foreign affiliate. Any deemed dividend would be subject to non resident WHT, as reduced by any applicable tax treaty. Page 2 of 44

3 The 2012 Budget further proposed to disregard the paid up capital (PUC) of any shares of the Canadian subsidiary that were issued by the Canadian subsidiary as consideration for the acquisition of shares of the foreign affiliate. In this respect, the new rule would effectively broaden a similar cross border surplus stripping rule (involving Canadian affiliates) to cover these new transactions involving foreign affiliates. Finally, the 2012 Budget announced an exception for certain transactions that satisfied a business purpose test. In general terms, the factors necessary for this exception were directed towards determining whether it was reasonable to conclude that the investment in, and ownership of, the foreign affiliate belongs under the Canadian subsidiary more than in any other entity in the foreign parent's group. The Canadian government readily admitted that determining whether such an exception might be available in any case would not be straightforward. The new rules as introduced in the 2012 budget would be applicable to transactions that occur on or after the day the budget was announced, subject to certain grandfathered transactions. The Present FAD Rules High Level Following the 2012 Budget, taxpayers made various representations that resulted in certain modifications to the rules as originally proposed. Changes were introduced in 2012 and August What follows is a brief overview of the underlying principles in the FAD rules. Targeted Companies. The targeted companies are Canadian companies controlled by foreign companies. (Such a company is defined in the FAD rules simply as a corporation resident in Canada, or CRIC for short. Accordingly, you sometimes see these rules called the CRIC rules.) Targeted Investments. The targeted investments by the Canadian companies include shares of a foreign affiliate, capital contributions to a foreign affiliate, loans to a foreign affiliate, and shares of a Canadian company the assets of which are substantially foreign affiliate shares. Supporting rules deal with certain corporate migrations into Canada, as well as certain equity contributions by the foreign parent into the Canadian company. Page 3 of 44

4 Principal Tax Consequences. The targeted investment triggers a deemed dividend subject to WHT or an automatic reduction to available in bound, crossborder paid up capital (PUC) of shares held by the foreign parent company in the Canadian company. The apparent tax policy is that any such available crossborder PUC could otherwise have been used to return capital free of any deemed dividend (and withholding tax). Accordingly, the automatic reduction of PUC is essentially a proxy for this. The reduced PUC may be reinstated, in certain defined situations, if the targeted investment is later distributed back out of Canada. Key Exceptions. Three exceptions are available in concept. 1. The PLOI Regime. An exception is provided for a pertinent loan or indebtedness (PLOI). This allows the Canadian company to make certain loans to a foreign affiliate and elect that they be excluded from the FAD rules. The price of such an election is that the PLOI generally attracts the highest amount of deemed interest income under the existing interest imputation regime in Canada (generally the 3 month Government of Canada Treasury Bill rate plus 4%, set quarterly currently about 6%). Furthermore, if the PLOI has been funded with debt incurred by the Canadian company that has an interest rate that exceeds this deemed interest income on the PLOI, the deemed interest income on the PLOI increases to match this (higher) rate. In this respect, the PLOI rules ensure that the interest income included in the Canadian company s income in respect of the PLOI is at least equal to the interest payable on any related debt owing by the Canadian company. 2. Certain Reorganizations. A corporate reorganization exception is generally aimed at excluding certain defined direct and indirect acquisitions of foreign affiliate shares from the FAD rules, essentially where the shares acquired do not represent a new investment by the Canadian company in the foreign affiliate from an economic perspective. These exceptions do not apply to some reorganizations. Accordingly, careful review of any proposed restructuring is typically required to avoid unwanted surprises. Page 4 of 44

5 3. Canadian Centric Business Expansions. An exception for strategic business expansions allows Canadian subsidiaries to invest in foreign affiliates in certain narrowly defined circumstances. In concept, these contemplate (i) a Canadian subsidiary making a strategic acquisition of (or an investment in) a business that is more closely connected to its business than to those of foreign companies in the group, where (ii) the officers of the Canadian subsidiary, with the required Canadian nexus, are the predominant decision makers in both a commercial and economic sense. Unfortunately, this exception for strategic business expansions will be difficult to meet for many multinational groups. The above high level points should provide a sufficient understanding to recognize when a FAD issue may arise. However, the application of these rules to any situation requires a more in depth understanding of the specific provisions that may be engaged. Accordingly, Appendix A attached walks through the specific provisions in the FAD rules in some detail. ***** Page 5 of 44

6 APPENDIX A 1 The Present FAD Rules In Detail A. Triggering Conditions The rule in s (1) provides the conditions for the application of s (2), the latter being the main operative rule. By virtue of s (1), s (2) will apply to an investment (as defined in s (10)) in a non resident corporation (referred to in s and in this commentary as the subject corporation ) by a corporation resident in Canada (referred to in s and this commentary as the CRIC ) where three conditions are met. The first condition, in s (1)(a), is that the subject corporation must be a foreign affiliate of the CRIC immediately after the investment is made (or must become a foreign affiliate of the CRIC as part of a series of transactions or events that includes the making of the investment). By virtue of the series of transactions reference, s (2) can also apply where a portfolio (non foreign affiliate) interest in a nonresident corporation is acquired by a CRIC in contemplation of a future event as a result of which the non resident becomes a foreign affiliate of the CRIC. The second condition, in s (1)(b), is that the CRIC must be controlled by a nonresident corporation (referred to in s and in this commentary as the parent ) at the time the investment is made (or become so controlled as part of a series of transactions or events that includes the making of the investment). This condition generally distinguishes between Canadian based multinationals, to which the rules do not apply, and foreign based multinationals with Canadian subsidiaries, to which the rules are intended to apply. On August 16, 2013, proposed changes were released for s (1)(b). First, it is amended to ensure that if the parent does not control the CRIC at the investment time, 1 This narrative is taken to a large extent from the Technical Notes helpfully produced by the Department of Finance in connection with the FAD rules. Page 6 of 44

7 the condition in that paragraph is satisfied and s (2) may therefore apply only if the parent acquires control of the CRIC after the investment time and as part of the series that includes the investment. The rule in s (2) will not apply where the CRIC becomes controlled by a non resident corporation prior to, and as part of the series of transactions or events that includes, the making of the investment, provided that: the CRIC is not controlled by a non resident corporation at the investment time, and the CRIC does not become controlled by a non resident corporation after the investment time and as part of the series that includes the making of the investment. The second amendment provides a safe harbour, subject to certain restrictions where (i) the CRIC does not fully participate in the investment in the subject corporation (i.e., acquires preferred shares), or (ii) has its risk limited in respect of the investment in the subject corporation. Even with the addition of the safe harbour rule, s (1)(b) will continue to be satisfied where a non resident corporation controls the CRIC at the investment time because the requirement in s (1)(b)(i) would be met. Where a CRIC is not at the investment time controlled by a non resident corporation, but subsequent to the investment time and as part of a series becomes controlled by a non resident corporation, s (1)(b) will apply provided any of the conditions set out in s (1)(b)(i) to (iii)) is satisfied: At the investment time, the parent, either alone or together with persons with whom the parent does not deal at arm s length, owns shares of the CRIC that either give the holders thereof 25% or more of the votes that could be cast at any annual meeting of the shareholders of the CRIC, or have a fair market value of 25% or more of the fair market value of all the shares of the CRIC. For these purposes, ownership of the CRIC s shares by the parent and each person who does not deal at arm s length with the parent is to be determined as if all rights referred to in s. 251(5)(b) were immediate and absolute and the parent and each of those other persons had exercised those rights. The investment is an acquisition of shares of a subject corporation to which s (1)(b)(ii) applies because of subsection 212.3(19), i.e., the shares are in Page 7 of 44

8 substance preferred shares and the subject corporation is not a subsidiary wholly owned corporation. Under an arrangement entered into in connection with the investment, a person or partnership, other than the CRIC or a person related to the CRIC, has in any material respect the risk of loss or opportunity for gain or profit with respect to a property that can reasonably be considered to relate to the investment. This condition would be met, for example, where the CRIC s investment is funded by limited recourse debt from a non resident corporation that subsequently becomes its parent as part of the series of transactions or events that includes the making of the investment or where the CRIC has a right to sell the investment (i.e., a put right) to the parent, or a person that is not related to the CRIC, at some later time for a predetermined amount. The purpose of the safe harbor rules is to reduce impediments to corporate takeovers. The rules recognize that, if a non resident corporation does not own, at the investment time, an equity interest in the CRIC that allows the non resident corporation to materially influence the CRIC s investment decisions (i.e., 25% or more of the CRIC s equity as measured by votes or value), then the non resident cannot generally be considered to have caused the CRIC to make an investment in anticipation of the nonresident acquiring control of the CRIC. However, the rules also recognize that if a CRIC has limited risk associated with the making of an investment by virtue of either the nature or terms of the investment, or risk mitigating arrangements related to the investment the CRIC may be prepared to accommodate dumping transactions prior to an acquisition of control by a non resident corporation. These amendments apply in respect of transactions and events that occur after March 28, 2012, subject to an election to have them come into force on August 14, Example 1. NR Co, a non resident corporation, owns all of the shares of Canco 1, a corporation resident in Canada. As part of a series of transactions and events, the following events occur in sequence: Canco 1 acquires all of the shares of Canco 2, a corporation resident in Canada, from vendors with which NR Co and Canco 1 deal at arm s length. As a result, Canco 2 becomes controlled by NR Co. Page 8 of 44

9 New shares of Canco 1 are put up for sale through a public offering. As a result of the public offering, NR Co ceases to control Canco 1 and Canco 2. Canco 2 acquires all of the shares of Forco, a non resident corporation. The investment by Canco 2 in the shares of Forco did not occur while Canco 2 was controlled by a non resident corporation, nor did Canco 2 become controlled by a nonresident corporation after the investment time as part of a series of transactions. Rather, Canco 2 became controlled by NR Co only prior to the investment time and as part of the series. As such, the conditions in s (1)(b) are not satisfied, and s (2) will not apply, in respect of the investment by Canco 2 in the shares of Forco. Example 2. Canco 1 is a Canadian resident public company. Forco, a wholly owned foreign affiliate of Canco 1, owns an interest in a mining project located outside of Canada. Canco 1 requires funding in order to finance continued exploration and development of the project. NR Co, a non resident corporation, in order to partially fund the required investment in the project, acquires shares of Canco 1 that comprise 20% of the votes and value of all the shares of Canco 1. NR Co also advances a loan to Canco 1 with market terms, in order for Canco 1 to make an investment in Forco. The project turns out to be sufficiently promising such that NR Co (as part of the series of transaction that includes the initial share acquisition and loan) subsequently makes an offer, which is accepted by the shareholders of Canco 1, to acquire a controlling interest in Canco 1. The investment by Canco 1 in Forco is an investment to which s (2) would apply if the requirements in s (1)(b) were satisfied. With respect to the safe harbour in s (1)(b), it will apply if none of the conditions in s (1)(b)(i) to (iii) are satisfied. The condition outlined in s (1)(b)(i) is not satisfied because at the investment time NR Co, together with persons with which NR Co does not deal at arm s length, did not own at least 25% of the shares of Canco 1 (as measured by votes or value). As well, the investment in Forco is not an investment described in s (1)(b)(ii), nor did the CRIC enter into an arrangement in connection with the investment in Forco that limits its risk of loss or opportunity for gain or profit. Therefore, the investment by Canco 1 in Forco is not an investment that satisfies the requirements of s (1)(b) and s (2) will not apply. Page 9 of 44

10 Example 3. NR Co, a non resident corporation, is in advanced discussions with the shareholders of Canco 1, a corporation resident in Canada, to acquire all the shares of Canco 1. Canco 1 is not controlled by a non resident corporation. Prior to the acquisition of the shares of Canco 1, NR Co agrees to extend a loan to Canco 1 so that Canco 1 can acquire all the shares of Forco, a non resident corporation, from NR Co. The loan may be settled at any time, at the option of either Canco 1 or NR Co, by Canco 1 transferring the Forco shares back to NR Co. The shareholders of Canco 1 approve the takeover bid and NR Co acquires all the shares of Canco 1. Canco 1 becomes controlled by NR Co as part of the series of transactions or events that includes the making of the investment by Canco 1 in Forco. The rule in s (1)(b) will apply if any of the conditions in ss (1)(b)(i) to (iii) are satisfied. The limited risk repayment terms of the loan are an arrangement entered into in connection with the investment by Canco 1 in Forco under which a person other than Canco 1 (i.e., NR Co) has in a material respect the risk of loss or opportunity for gain or profit with respect to the property (i.e., the shares of Forco) acquired by Canco 1 on the investment. Therefore, the investment by Canco 1 in Forco is an investment that satisfies the requirements of s (1)(b) and s (2) will apply. The third condition, in s (1)(c), is that neither s (16) nor s (18) applies in respect of the investment. In general terms, s (16) provides an exception from the application of s (2) in circumstances where the investment is made by the CRIC in the context of a strategic business expansion. The rule in s (18) provides exceptions from the application of s (2) where the CRIC's investment in the subject corporation is made in the context of certain reorganization transactions that do not involve a new investment by the CRIC in the subject corporation. These are discussed further below. B. Main Rule New s (2) is the main (operative) rule and it applies when the three conditions in s (1) are satisfied. The rule in s (2) can apply to deem dividends to be paid to the parent by the CRIC or can cause the paid up capital (PUC) of the shares of the CRIC to be reduced. Page 10 of 44

11 Additional rules ensure that contributed surplus arising in connection with a targeted investment receives the same treatment that would apply to PUC. The definition of equity amount in proposed s. 18(5) excludes such contributed surplus from the computation of a CRIC s debt to equity ratio for the purposes of the thin capitalization rules. Similarly, ss. 84(1)(c.1) (c.3) ensure that a deemed dividend will arise if such contributed surplus is converted to PUC. The rule in s (2)(a) deems a dividend to be paid by the CRIC to the parent in an amount equal to the fair market value of any properties transferred, obligations assumed or incurred, or benefits otherwise conferred, by the CRIC, or property transferred to the CRIC in repayment of an amount owing to the CRIC, that can reasonably be considered to relate to the investment in the subject corporation. The result of a deemed dividend under s (2)(a) is that the parent is subject to Part XIII dividend WHT under s. 212(2). The reference in s (2)(a) to benefit otherwise conferred is intended to capture any other means by which the CRIC transfers value to the subject corporation (for example, a forgiveness of debt) and is meant to be interpreted and applied in a fashion similar to that of the shareholder benefit conferral rule in s. 15(1). (The contribution of capital rule in s (10)(b) has corresponding language.) However, under the new secondary adjustment rules in s. 247, s (2) will not apply to a benefit conferral to the extent that s. 247(12) applies in respect of the benefit conferral, as provided under s. 247(15). This avoids a double count. The rule in s (2)(b) causes the PUC of the CRIC to be reduced where the creation of the PUC is related to an investment in a subject corporation. Accordingly, where a subject corporation is transferred by the parent to the CRIC in exchange for shares of the CRIC, any PUC increase resulting from that transfer would be negated. Where, for example, a parent first contributes cash to the CRIC in exchange for shares of the CRIC with PUC equal to the amount of the cash, and the CRIC subsequently uses that cash to make an investment in a subject corporation, it is intended that only the deemed dividend rule apply the PUC creation would not be considered to relate to the investment, as it is one step removed. It is similarly intended that only the deemed dividend rule would apply where a contribution of capital is made (rather than a contribution in exchange for shares), and that none of s. 84(1)(c.1) to (c.3) would apply to prevent such contributed surplus from subsequently being converted into PUC. Page 11 of 44

12 Similar reasoning applies in situations where a CRIC borrows money and uses the proceeds to purchase shares or debt of a foreign affiliate the incurring of the debt itself is not intended to give rise to a deemed dividend: only the cash payment is intended to give rise to a deemed dividend. An election is available under s (3) to have the dividend deemed to have been paid by certain other corporations resident in Canada rather than the CRIC and, in certain circumstances, to have a non resident corporation other than the parent be deemed to be the recipient of the dividend. It is also possible, in many cases, for a deemed dividend to be reduced by certain amounts of PUC, as discussed below under ss (6) and (7). The reasonably considered to relate language in s (2) is mainly intended to deal with situations in which the indirect acquisition rule in s (10)(f) is applicable, i.e., where the CRIC acquires foreign affiliate shares indirectly by acquiring shares of a Canadian corporation, in certain circumstances. In these situations, it would often be the case that the acquired Canadian corporation would also own assets other than foreign affiliate shares and thus, it is necessary to reasonably allocate the consideration paid by the CRIC to the foreign affiliate assets. In the absence of specific factors that indicate otherwise, it would be expected that the most reasonable way to allocate the consideration would be on a pro rata basis based on the fair market value of the underlying assets acquired. Where applicable, paragraph 212.3(2)(a) deems a dividend to be paid by a CRIC to its parent in an amount equal to the fair market value of any properties transferred, obligations assumed or incurred, or benefits otherwise conferred, by the CRIC, or property transferred to the CRIC in repayment of an amount owing to the CRIC, that can reasonably be considered to relate to the investment in the subject corporation. The result of a deemed dividend under paragraph 212.3(2)(a) is that the parent is subject to Part XIII dividend withholding tax under subsection 212(2). On August 16, 2013, an amendment was proposed to s (2)(a) to replace the reference to investment time with dividend time, which is defined in s (1.1) discussed below. This change ensures an appropriate result where a CRIC makes an investment in a foreign affiliate at a time when the CRIC is not yet controlled by a non Page 12 of 44

13 resident corporation, and the CRIC subsequently becomes so controlled as part of the series of transactions or events that includes the making of the investment. The dividend withholding tax rate to be applied may be reduced under an applicable tax treaty. By providing that the deemed dividend occurs at the dividend time generally defined by s (1.1) as the time when the parent acquires control of the CRIC (as long as control is acquired within 180 days after the investment time) rather than at the investment time, the amendment generally ensures that the parent may benefit from the most favorable withholding rate reduction under the applicable treaty. If the parent does not acquire control within 180 days of the investment time, s (1.1) provides that the dividend time occurs 180 days after the investment time, which may result in a higher withholding tax rate (depending on the terms of the applicable tax treaty). This amendment applies in respect of transactions and events that occur after March 28, 2012, subject to an election to have it come into force on August 14, C. Dividend Time On August 16, 2013, proposed new s (1.1) was added to define dividend time in respect of an investment for the purposes of s The dividend time in respect of an investment is if the CRIC is controlled by the parent at the investment time (within the meaning of s (1)), the investment time (s (1.1)(a)); or in any other case, the earlier of (i) the first time, after the investment time, at which the CRIC is controlled by the parent, and (ii) the day that is 180 days after the day that includes the investment time (s (1.1)(b)). If the CRIC is not controlled by the parent at the investment time, and the parent does not acquire control within 180 days of the investment time, the dividend time will occur 180 days after the investment time, which could have implications for the parent, as described in further detail in the commentary on s (2)(a) and s (7). Dividend time is relevant for the purpose of determining the time at which a dividend is deemed to be paid under s (2)(a). It is also relevant in determining for the Page 13 of 44

14 purposes of the PUC offset rule in s (7), which may reduce the amount of the deemed dividend under s (2)(a) the measurement time for the relevant PUC adjustment. Corresponding amendments are made to s (2)(a) and s (7), in each case replacing references to investment time with dividend time. This amendment applies in respect of transactions and events that occur after March 28, 2012, subject to an election to have it come into force on August 14, D. Shifting to Other Entities The rule in s (3) provides an election that allows for all or a portion of a dividend that would otherwise be deemed, under s (2)(a), to be paid by the CRIC to the parent to instead be deemed to be paid by certain other Canadian resident corporations in the corporate group (that are qualifying substitute corporations, as defined in subsection 212.3(4)), to either the parent or another non resident corporation in the group. The amounts of the dividends deemed to be paid by the qualifying substitute corporations and the CRIC are agreed to in the election, which, in order to be valid, must allocate the entire amount of the deemed dividend otherwise arising under s (2)(a) to classes of shares of qualifying substitute corporations and of the CRIC. Where an election is made under s (3), s (7) provides rules that, in certain circumstances, allow the deemed dividends to be offset against, and therefore reduce, the paid up capital (PUC) of the classes of shares of the qualifying substitute corporations and the CRIC in respect of which the dividends are deemed to be paid. Significant changes were introduced to s (3) on August 16, The most significant change is that the scope of the election under the rule is more limited: it no longer has any impact on the PUC offset under s (7), which now applies without the need for an election (i.e., it applies automatically). As a result of this amendment, the election under s (3) is limited to determining the payer and the payee of the deemed dividend under s (2)(a). The subsection allows an election to be made to have the dividend deemed to have been paid by either the CRIC or a qualifying substitute corporation, as agreed on in the election; and to have been paid to, and received by, either the parent or a non resident corporation that does not deal at arm s length with the parent, as agreed on in the election. Page 14 of 44

15 By allowing taxpayers to elect as payee any non resident corporation that does not deal at arm s length with the parent, the amendment provides greater flexibility than the current rules, which allow only non resident corporations controlled by the parent to be payees. Subsection 212.3(3) is also amended to ease the filing requirements for the election by removing the requirement that all qualifying substitute corporations in respect of the CRIC be parties to the election; the only qualifying substitute corporation that is required to be a party to the election is a qualifying substitute corporation that the CRIC elects to be the payer of the deemed dividend; and providing that the election must be filed on or before the filing due date of the CRIC for its taxation year that includes the dividend time, rather than, under the current rules, by the earliest of the filing due dates of the CRIC and the qualifying substitute corporations for their taxation years that include the time the investment is made. These amendments apply in respect of transactions and events that occur after March 28, 2012, subject to an election to have them come into force on August 14, A qualifying substitute corporation is defined in s (4), in respect of a CRIC, for the purposes of s A qualifying substitute corporation is defined as a Canadianresident corporation that is controlled by the parent corporation of the CRIC and that has an equity percentage (as defined in s. 95(4)) in the CRIC, where at least one share of the capital stock of the corporation is owned by the parent or a non resident corporation with which the parent does not deal at arm's length. This definition is relevant for the purposes of the dividend substitution election in s (3) and the dividend/puc set off rules in ss (6) and (7). Generally, the qualifying substitute corporation and dividend substitution concepts are meant to accommodate structures where one or more other Canadian resident corporations are situated between the parent and the CRIC in the corporate chain. On August 16, 2013, the rule was amended to provide that a Canadian resident corporation will satisfy the control requirement in this rule if it is controlled either by Page 15 of 44

16 the parent or by a non resident corporation with which the parent does not deal at arm s length. This amendment addresses, in particular, the situation where a qualifying substitute corporation is not controlled by the parent because the actual parent corporation that controls the related group is deemed by s (15)(a) to not control the CRIC and thus is not the parent for purposes of s This amendment applies in respect of transactions and events that occur after March 28, 2012, subject to an election to have it come into force on August 14, E. PUC Offset Rules The rules in s (6) and (7) allow for dividends that are otherwise deemed to arise under ss (2)(a) or (3)(b) to be offset against the PUC of the shares of the CRIC, or qualifying substitute corporations in respect of the CRIC, in certain circumstances. The rule in s (6) provides the conditions for s (7) (the operative rules) to apply. The August 16, 2013, proposals would repeal s (6). Substantial amendments were also made to s (7), which now contains both the operative PUC offset rules and the conditions for their application. The most significant change is that, in all cases where the conditions for their application are satisfied, the PUC offset rules now apply automatically to offset the PUC in respect of relevant shares against the dividend otherwise deemed under s (2)(a). Corresponding amendments are made to s (3) to reflect the fact that an election is no longer required in order to have a PUC offset. The elimination of the election does not constitute a substantive change. The election only allowed the CRIC to choose whether to have the PUC offset apply. It did not generally permit the CRIC to choose the specific classes of shares whose PUC is used to offset the deemed dividend or the amount of PUC from each such class of shares used for the offset. Amended s (7) contemplates two types of situations. The first is where the amount of the dividend that would, in the absence of s (7), be deemed under s (2)(a) to have been paid and received is equal to or greater than the total of all amounts comprising the PUC in respect of a cross border class of shares immediately before the dividend time. Where this is the case: Page 16 of 44

17 the amount of the deemed dividend is reduced by the total PUC of the crossborder classes immediately before the dividend time, and the PUC of each of the cross border classes having reduced, and been offset against, the deemed dividend is reduced to nil. For the purposes of s (7), a class of shares in the capital stock of the CRIC, or of a qualifying substitute corporation, is a cross border class if any shares of that class are owned at the dividend time by the parent or another non arm s length non resident corporation. The second type of situation is where the amount of the deemed dividend, determined without reference to s (7), is less than the PUC of all cross border classes immediately before the dividend time. Where this is the case the amount of the deemed dividend is reduced to nil, as it is fully offset by the PUC in respect of the cross border classes, and in computing, at or at any time after the dividend time, the PUC of the crossborder classes of shares of the CRIC or of a qualifying substitute corporation, there is to be deducted, in total, the amount of the dividend. in determining the amount to be deducted in respect of any particular crossborder class, there is to be allocated such amount as results in the greatest total reduction of the PUC in respect of shares of cross border classes that are owned by the parent or another non arm s length non resident corporation. Under ss (7)(b)(ii) and (iii), the deemed dividend must be allocated first to the class of shares of the CRIC or qualifying substitute corporation of which the parent or non arm s length non resident owns the greatest proportionate share at the dividend time; then, any remainder, to the class of which the parent or non arm s length nonresident owns the second greatest proportionate share; and so on. The rule in s (7)(c) also provides a filing requirement where the amount of the deemed dividend otherwise arising under s (2)(a) is reduced because of s (7)(a)(i) or s (7)(b)(i). In that case, the CRIC must file with the Minister of Page 17 of 44

18 National Revenue, on or before the 15th day of the month following the month that includes the dividend time, a prescribed form setting out: the amounts, immediately before the dividend time, of the paid up capital of each cross border class; the paid up capital of the shares of each cross border class that are owned by the parent or another non resident corporation with which the parent does not, at the dividend time, deal at arm s length; and the reduction under ss (7)(a)(ii) or (b)(ii) in respect of each cross border class. These amendments apply in respect of transactions and events that occur after March 28, 2012, subject to an election to have them come into force on August 14, F. PUC Reinstatement Rules The rule in 212.3(9) allows for a reinstatement of PUC in respect of a class of shares of a CRIC or a qualifying substitute corporation immediately before a reduction of capital in certain circumstances where the PUC was initially reduced by the operation of ss (2)(b) or (7)(b). The amount by which the PUC may be reinstated is the least of three amounts. The first is the amount of the distribution or reduction of PUC by the particular corporation. The second is the amount by which the PUC of the particular corporation was reduced by the operation of s (2)(b) or (7)(b). The third amount is based on the extent to which the distribution is traceable to property acquired as an investment (referred to here as the original property ) in a subject corporation. For this purpose, two situations are contemplated: either i) the original property consists of foreign affiliate shares, and those shares or substituted shares are distributed by the particular corporation, in which case the amount is based on the fair market value of the distributed shares; or ii) proceeds from a disposition of subject corporation shares or of a debt owing by a subject corporation, or dividends or reductions of capital in respect of such shares, are distributed, in which case the amount is based on the amount of the proceeds, dividends or reductions of capital. In the latter case, the particular corporation is required to trace the proceeds, dividends or Page 18 of 44

19 reductions of capital to the distribution and to establish that they occurred within 180 days of the distribution. On August 16, 2013, the rule in s (9) was amended in four respects. First, in order to clarify that the PUC reinstatement can apply not only where the particular Canadian corporation reduces PUC as part of a return of capital, but also where such PUC is reduced as a result of a redemption, acquisition or cancellation of shares by the particular Canadian corporation, the following amendments are made: The existing requirement in the preamble to s (9) that the particular corporation reduces the PUC in respect of the relevant class of shares is modified to require that the PUC is reduced, to clarify that the requirement can be met where the PUC is reduced as a result of a redemption, acquisition or cancellation of shares. Minor changes are also made to s (9)(a) to clarify its application in context of a redemption, acquisition or cancellation of shares. The reference in s (9)(c)(i) to the property distributed on the reduction of paid up capital is replaced with the paid up capital is reduced at the subsequent time as part of or because of a distribution of property. This change reflects the fact that in the case of a share redemption, for example, the paid up capital reduction might be considered to occur because of a distribution of property. Second, s (9)(b)(i) is amended to recognize that both s (2)(b) and s (7) may apply in respect of the same investment to reduce the PUC of shares and that a reinstatement of the PUC reduced under both provisions is potentially available. Third, the preamble to s (9) is amended to refer to investments described in any of ss (10)(a) to (f), and s (9)(c)(ii)(A)(III) is introduced, to extend the application of the PUC reinstatement rules to certain circumstances where the original property is a debt owed by a subject corporation, as described in ss (10)(c) or (d) or s (10)(e)(i). This permits the PUC reduced under s (2)(b) or s (7) to be reinstated when the particular corporation has received a repayment of, or proceeds from the disposition of, the debt of the subject corporation that arose from the investment, or has received interest on the debt. Page 19 of 44

20 Fourth, s (9)(c)(ii)(B) is introduced. It effectively provides that, where s (9)(c)(ii)(A) applies, a PUC reinstatement is available only if the property received by the particular corporation is traceable to the original property and is not acquired as part of an investment in a subject corporation to which s (2) does not apply. This ensures that there is no PUC reinstatement where, for example, a particular Canadian corporation receives shares or another interest in a foreign affiliate if s (2) does not apply to the investment because of an exception in s (16) or (18). In that case, the newly acquired shares or other interest in the foreign affiliate would not be expected to enhance the income earning capacity of the CRIC s Canadian operations in a manner warranting a PUC reinstatement. If the particular Canadian corporation replaces the original property with a new property, the new property was acquired as part of an investment in a subject corporation to which s (2) does not apply, and the particular Canadian corporation subsequently distributes other property, then the PUC reinstatement rule will not apply because the amount determined under s (9)(c)(ii) will be nil. However, the restriction in s (9)(c)(ii)(B) would not apply, for example, if the original property is disposed of for cash because the cash would not be property acquired as part of an investment in a subject corporation. In addition, the restriction would not apply if the new property acquired was acquired as part of an investment in a subject corporation to which s (2) applies. These amendments apply in respect of transactions and events that occur after March 28, 2012, subject to an election to have them come into force on August 14, 2012, except that s (9)(c)(ii)(B) applies only in respect of transactions and events that occur on or after August 16, G. Types of Investment in Foreign Affiliate An investment in a subject corporation made by a CRIC is defined in s (10). By virtue of s (10)(a), an investment includes an acquisition of shares of the subject corporation by the CRIC. This includes acquisitions by the CRIC of newly issued shares of the subject corporation. It also includes acquisitions by the CRIC of issued and outstanding shares of the subject corporation from the CRIC's non resident parent corporation, another corporate group member or an arm's length person or partnership. Page 20 of 44

21 By virtue of s (10)(b), an investment includes a contribution of capital to the subject corporation by the CRIC. Thus, a transfer of property by the CRIC to the subject corporation is an investment even if the CRIC does not take back any shares or debt of the subject corporation. In addition, for these purposes, s (10)(b) deems a contribution of capital to include any transaction or event under which a benefit is conferred on the subject corporation by the CRIC. This benefit conferral rule is similar to the rule in s. 15(1) that applies in the shareholder benefit context. By virtue of s (10)(c), an investment includes a transaction under which an amount becomes owing by the subject corporation to the CRIC, unless the amount owing satisfies either of two exceptions. The first exception, in s (10)(c)(i), is for an amount that becomes owing to the CRIC in the ordinary course of the CRIC's business and is repaid, other than as part of a series of loans and repayments, within 180 days of the day it becomes owing. The ordinary course of business exception could apply, for example, where the CRIC supplies property to the subject corporation on credit in the ordinary course of the CRIC's business operations (and the resulting debt is repaid in the manner required by that exception). The second exception, in s (10)(c)(ii), is for an amount owing that the CRIC and the parent have jointly elected under paragraph 212.3(11)(c) to have treated as a pertinent loan or indebtedness (PLOI). This is discussed below. Subject to the foregoing two exceptions, s (10)(c) is generally intended to include, as investments the following: loans made by the CRIC to the subject corporation; transactions resulting in trade debts or other unpaid purchase price owing by the subject corporation to the CRIC; and any other transaction as part of which an amount becomes owing by the subject corporation to the CRIC. Paragraph 212.3(10)(c) is amended to add a third exception for an amount that is owing by a subject corporation to a CRIC because a dividend has been declared, but not yet paid, by the subject corporation (within the meaning of s (1)). By virtue of s (10)(d), an investment includes an acquisition of a debt obligation of the subject corporation by the CRIC from another person, subject to two exceptions. The first exception, in s (10)(d)(i), is for an acquisition made in the ordinary course of the business of the CRIC from a person with which the CRIC deals, at the time of the acquisition, at arm's length. The second exception, in s (10)(d)(ii), is for an Page 21 of 44

22 amount owing that the CRIC and the parent have jointly elected under paragraph 212.3(11)(c) to have treated as a PLOI. The rule in s (10)(d) is intended to include acquisitions of outstanding debts of a subject corporation from any person (or, by virtue of the look through rules in s (25), any partnership), whether dealing at arm's length or non arm's length with the CRIC. The rule in s (10)(e) provides that an investment includes an extension of either the maturity date of a debt obligation owing by the subject corporation to the CRIC (other than a debt obligation that is a pertinent loan or indebtedness, as defined in s (11), immediately after the extension) or the date on which shares of the subject corporation held by the CRIC are to be redeemed, acquired or cancelled by the subject corporation. For example, where the subject corporation issued a debt obligation or preferred shares to the CRIC before March 29, 2012 (i.e., the effective date of the foreign affiliate dumping rules) that would have been an investment under s (10)(c) or s (10)(a), respectively, had they instead been issued after March 28, 2012, an extension of the maturity date of the debt or the redemption date of the preferred shares would constitute an investment. Where, instead, the debt obligation or the shares are issued by the subject corporation to the CRIC after March 28, 2012, and s (2) applies to such investment, a subsequent extension of the maturity or redemption date, as the case may be, would result in a second investment to which s (2) would apply. For the purposes of determining the quantum of a dividend the CRIC is deemed to pay to its non resident parent under s (2)(a) in respect of an investment described in s (10)(e), s (5) deems the CRIC to have transferred property to the subject corporation (that relates to the investment) with a fair market value equal to the amount owing on the debt obligation, or the fair market value of the shares, immediately after the investment. These rules are intended to give results similar to those that would occur had the debt been repaid and re loaned, or had the shares been redeemed and re issued, as the case may be, instead of being extended. The rule in s (10)(f) provides that an investment includes certain indirect acquisitions of foreign affiliate shares by a CRIC, through the direct acquisition of shares Page 22 of 44

23 of another Canadian resident target corporation. (For these purposes, it is important to take into account the partnership look through rules in s (25).) Specifically, where a CRIC acquires directly shares of another Canadian resident target corporation which itself holds, directly or indirectly, shares of one or more foreign affiliates the indirect acquisition of each such foreign affiliate by the CRIC will be considered a separate investment in a subject corporation if the total fair market value of all the foreign affiliate shares held, directly or indirectly, by the Canadian target corporation comprises more than 75% of the total fair market value of all the properties owned by the Canadian target. The parenthetical language in s (10)(f) requires that the computation of the total fair market value of all the properties owned by the Canadian target corporation be made without taking into account any debts of any Canadian corporation in which the Canadian target has a direct or indirect interest. As a result, where the Canadian target owns shares of another Canadian corporation, the fair market value of those shares is to be determined for these purposes without taking into account any debts of that other corporation. The debts of the Canadian target are also not taken into account because the 75% test is applied based on the properties of the Canadian target. The other computation required to be made in applying the 75% test in s (10)(f) is of the total fair market value of all the shares the Canadian target corporation owns, directly or indirectly (i.e., through shareholdings of other corporations), of its foreign affiliates. This computation includes only the value of the Canadian target's proportionate equity interest in its foreign affiliates, rather than the total value of each foreign affiliate. In addition, since the parenthetical language in s (10)(f) excludes only debts of Canadian corporations, any debts of foreign affiliates will be reflected in their share values for these purposes. Finally, where a foreign affiliate itself owns shares of another foreign affiliate of the Canadian target, such that the value of the upper tier foreign affiliate's shares reflects that of the lower tier affiliate, the rule against double counting, in s (14)(b), precludes taking the value of the lowertier foreign affiliate into account more than once. The rule in s (14) provides tests for applying the indirect acquisition rule in s (10)(f). The rule in s (14)(a) provides an anti avoidance provision that effectively extends the time for applying the 75% test in s (10)(f) to the entire Page 23 of 44

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