SOLVING SUBPART F DEFERRING INVESTMENT INCOME EARNED BY A CFC IN CANADA

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1 February 5, 2015 Number 2239 SOLVING SUBPART F DEFERRING INVESTMENT INCOME EARNED BY A CFC IN CANADA US citizens in Canada who own stock in Canadian-controlled private corporations Max Reed 1 ( CCPCs ) often run into difficulties. For US tax purposes, these corporations are often classified as controlled foreign corporations ( CFCs ). This means that passive income earned by these corporations (referred to as Subpart F income ) is normally attributable to the US shareholder directly, so no deferral is possible. Worse, the income is phantom income i.e., there is US tax owed but no cash is distributed from the CFC to pay the 2. How investment income earned by CCPCs is taxed in Canada... 2 tax. Thankfully, there may be a solution. Income that would normally be classified as Subpart F income is exempted from this classification if the corporation pays tax at a 3. The high tax rate of at least 31.5% in the country where the CFC operates. 2 The technical term for exclusion... 2 this is the high tax exclusion and it is found in section 954(b)(4) of the Internal Revenue Code. 3 Here, I suggest that the high tax exclusion can be used to exempt 4. Planning investment income earned by CCPCs from classification as Subpart F income. Such an opportunities... 4 approach would minimize the consequences of operating through a CFC and may help achieve a measure of tax deferral for US citizens in Canada. To start out, I survey the 5. Conclusion... 4 CFC regime. Then I briefly explain how investment income earned by a CCPC is taxed and how the RDTOH credit functions. The RDTOH credit, I argue, does not need to be Recent Cases... 5 taken into account in determining the effective Canadian corporate tax rate paid by a CCPC for the purposes of the high tax exclusion. I conclude with a brief discussion of possible planning strategies. 1. Overview of the CFC regime A CCPC will be classified as a CFC for US tax purposes if more than 50% of the voting power or value of stock is owned by US shareholders. 4 A US shareholder is defined as a US person who owns 10% or more (directly or indirectly) of the combined voting power of all classes of voting stock in the corporation. 5 A US person includes US citizens and residents, US corporations, US trusts, and US partnerships. Generally, the adverse US federal income tax consequences of owning stock in a CFC are as follows. First, if the corporation has been a CFC for an uninterrupted period of 30 days or more during a taxable year, the 10% or more US shareholders of the CFC would recognize deemed income in an amount equal to such shareholder s pro rata share of the CFC s Subpart F income and to the extent of any investments of the CFC in US property. 6 Subpart F income, limited to the current earnings and profits of the CFC, includes foreign base company income, certain insurance income, income from boycott operations, illegal payments to foreign governments, and other income earned in specific countries. Foreign base company income includes foreign personal holding company income. 7 In turn, foreign personal holding company income includes income from dividends, interest, rents, royalties, 8 capital gains, commodities transactions, net foreign currency gains, and income from notional principal contracts and certain personal service contracts. 9 Foreign base 1

2 TAX TOPICS 2 company income also includes income from (1) the sale of certain property purchased from a related person; (2) the sale of personal property to, or on behalf of, a related person; or (3) the purchase of personal property on behalf of a related person, where the property is (a) manufactured, produced, grown, or extracted outside the country in which the CFC is organized; and (b) sold or purchased, as the case may be, for use, consumption, or disposition outside such non-us country. 10 Finally, foreign base company income also includes income derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services which are performed for or on behalf of a related person and outside the country in which the CFC is organized How investment income earned by CCPCs is taxed in Canada CCPCs pay Canadian corporate tax ranging from 45 50% on investment income. The exact rate differs depending on what province the CCPC operates in and what type of income it is. This rate is reduced by a refundable dividend credit called the refundable dividend tax on hand ( RDTOH ). When a CCPC earns investment income, it can post an amount equal to 26.67% of that income to its RDTOH account. 12 When the CCPC later pays a taxable dividend to its shareholders it can claim a tax credit equal to $1 for every $3 it pays, up to the limit of its RDTOH account. RDTOH credits can be used to reduce Canadian corporate income tax on any kind of income not just investment income. Further, the dividend doesn t have to be paid out of the corporation s investment income. 13 A full exploration of how RDTOH works is beyond the scope of this article and is available elsewhere The high tax exclusion If a CFC pays foreign corporate tax at a rate equal to or greater than 90% of the highest US corporate tax rate (currently 35%) on an item of income that would normally be Subpart F income, then that item of income can be excluded from Subpart F income. 15 Put differently, when the effective foreign tax rate is 31.5% or higher for a particular item of income, it can be excluded from Subpart F income. Since investment income earned by a CCPC is taxed at between 40 50%, it seems intuitive that it would be excludable from Subpart F income using the high tax exclusion. However, Code section 954(b)(4) requires that the effective rate of income tax (the effective tax rate ) be used to determine whether an item of income earned by a CFC is excludable from Subpart F using the high tax exclusion. The question then becomes: must the RDTOH credit that is generated when a CCPC pays tax on investment income be taken into account when determining the effective tax rate paid by the CFC for the purposes of the high tax exclusion? My answer is no: the RDTOH credit likely does not have to be taken into account to determine the applicability of the high tax exclusion to investment income earned by a CCPC. There are a number of steps required to arrive at this conclusion. At the outset, it is worth pointing out that if a CCPC uses an RDTOH credit (or another type of credit) to push its Canadian corporate tax rate below 31.5%, then this strategy does not work. It only works if the RDTOH credit is banked for future years and the Canadian corporate tax rate remains at least 31.5% on an item of income. To begin, examine what constitutes an item of income for the purposes of the high tax exclusion. The term item of income is defined quite specifically. 16 The definition depends on what type of income it is. If the income in question is foreign personal holding company income (discussed in section 1), then the definition of what constitutes an item of income for the purposes of the high tax exclusion has two elements. First, the income has to fall into a single grouping under the rules set out in (c)(3), (4), and (5). Second, the income must also fall into one single category of those set out in paragraphs (i) through (v) of Reg (c)(1)(iii)(A)(1). 17 Take each aspect of the definition in turn. The rules under Reg (c)(3) group items of income according to the amount and type of Canadian tax that will be imposed on them. No investment income earned by a CCPC will be subject to Canadian withholding tax, but it will be subject to Canadian corporate tax. 18 As such, all investment income earned by a CFC in Canada will be under the same category for the purposes of (c). Thus, it is the categories set out in paragraphs (i) through (v) of Reg (c)(1)(iii)(A)(1) that will determine how an item of income is defined. Dividend, interest, rent, royalty, and annuity income from passive sources is lumped together for the purposes of calculating the high tax exclusion. Similarly, gain from the sale of property that produces passive income is a separate category. In sum, to figure the effective rate of income tax for the purposes of a CCPC, all passive income save for capital gains is grouped into one category and capital gains generated by the sale of assets that generate passive income are grouped into another. Note that capital gain income generated by the sale of assets which do not produce active income is not classified as Subpart F income to begin with and, as such, is not germane to this discussion.

3 TAX TOPICS 3 Second, consider the time period in which that analysis takes place. For the purposes of figuring the high tax exclusion, the effective tax rate is analyzed with respect to the taxable year of the controlled foreign corporation. 19 Arguably, when an analysis is performed with respect to the CFC s tax year, then consequences in a future tax year are irrelevant. Third, the Treasury Regulations provide guidance that a future tax credit is to be ignored in determining the effective rate of tax for the purposes of examining the applicability of the high tax exclusion. According to Reg (d)(2), the effective tax rate for a particular item of income is determined under Reg (d)(3). In turn, Reg (d)(3)(i) defines how the effective tax rate for Subpart F income that is not passive foreign personal holding company income should be determined. Reg (d)(3)(i) states that future reductions in tax due to a distribution to shareholders should not be taken into account for the purposes of calculating the effective tax rate for the high tax exclusion. While the universe of Subpart F income that does not include passive foreign personal holding company income may not be large (or at all interesting for the purposes of this analysis), this provision explicitly states that a future reduction in foreign taxes due to a distribution to shareholders will not impact the assessment of a CFC s effective tax rate for the purposes of the high tax exclusion. An RDTOH credit is a future reduction in Canadian (foreign) taxes that is only attributable to a distribution of income to shareholders. When combined with the general proposition under Reg (d)(1)(ii) that the analysis is conducted with respect to the current tax year of the corporation, there is a good argument to be made that future RDTOH credits should not be taken into account for the determination of the effective tax rate paid by a CFC on income other than foreign personal holding company income. Of course, such income is normally (without reference to RDTOH) taxed at a rate below 31.5% in Canada and, as such, this is an academic point. Still, it remains important for establishing the context of how the Treasury Regulations deal with calculating the effective tax rate when the tax rate will be reduced by future distributions to shareholders. RDTOH credits also do not need to be used in establishing the effective tax rate for an item of income that is foreign personal holding company income. The route to arrive at this conclusion is longer than it is for items of income which are not foreign personal holding company income. Recall that foreign personal holding company income includes income from dividends, interest, rents, royalties, capital gains (from the sale of assets that produce passive income), commodities transactions, net foreign currency gains, and income from notional principal contracts and certain personal service contracts. 20 The definition of effective tax rate for the purposes of the high tax exclusion for foreign personal holding company income is set out in Reg (d)(3)(ii). In turn, Reg (d)(3)(ii) simply outsources the task of establishing the effective tax rate to the regulations under (c) (foreign tax credits for passive income). An analysis of the rules under (c) reveals that RDTOH credits generated for future use should not be included in the calculation of the effective tax rate for the purposes of the high tax exclusion. Reg (c)(6)(i) states that the determination of whether income is high-taxed or not is made in the taxable year the income is included in the gross income of the US shareholder. This is parallel to Reg (d)(1) (the general rule which is applicable to the entire high tax exclusion section) and suggests that reductions of tax in future tax years should not be incorporated into the analysis of the effective tax rate for the purposes of section 954(b)(4). Similarly, Reg (c)(7)(i) mirrors the text of Reg (d)(3)(I), which is used to establish the effective tax rate for Subpart F income which is not foreign personal holding company income. Reg (c)(7)(i) states that a future reduction of tax due to a distribution of dividends is not taken into account to determine the effective tax rate for the purposes of the high tax exclusion. Finally, Reg (c)(7)(iii) clarifies the relationship between Reg (c) and the determination of the effective tax rate for the purposes of the high tax exclusion under section 954(b)(4). It holds that the rules under section 954(b)(4) shall be applied without regard to the subsequent reduction of foreign tax. In other words, for the purposes of determining the applicability of the high tax exclusion, the rules under Reg (c) ignore a future reduction in foreign tax. This is a divergence from the way that the rules under Reg (c) are applied to the determination of foreign tax credits. Examples 6 and 7 under the regulations illustrate this point. In example 6, the taxpayer has to re-determine its foreign tax credits because of a subsequent reduction in tax due to a dividend that was paid out. Tax that is refundable is generally not available as a foreign tax credit. 21 Example 6 does not, however, deal with an election to use the high tax exclusion. Further, Reg (c)(7)(iii) differentiates the analysis under the Reg rules between their application for foreign tax credit purposes and their application for the purposes of the high tax exclusion. This distinction is confirmed in example 7. In example 7, the taxpayer is able to apply the high tax exclusion to exclude the passive income from categorization as Subpart F income even though that passive income was ineligible for use for foreign tax credit purposes.

4 TAX TOPICS 4 In sum, as long as the tax rate, excluding a future reduction in tax generated by RDTOH credits, for the total dividends, interest, rents, royalties, and annuities earned by a CCPC exceeds 31.5% in the current tax year, this income can escape classification as Subpart F income. The same is true of capital gains. However, given that only 50% of capital gain income is taxable, as a practical matter, it is unlikely to meet the 31.5% threshold. The next section will consider planning opportunities. 4. Planning opportunities The most obvious application of this strategy is to eliminate some of the adverse US tax consequences of owning a CCPC that is also a CFC. The obvious drawback of this strategy is that it keeps the Canadian corporate tax payable at a level higher than it might otherwise be. However, RDTOH credits can be used to reduce Canadian corporate tax on income streams, such as active business income, that have no risk of treatment as Subpart F. For individual US persons who own Canadian investment corporations, or are unwittingly put in structures that are tax efficient in Canada but have adverse US tax consequences, the Subpart F consequences can be deferred until the individual is sufficiently US tax compliant so that US person status can be terminated. After renunciation, the individual would have a surplus of RDTOH tax credits and would pay a low rate of Canadian corporate tax for many years following the termination of US person status. 5. Conclusion Subpart F income can be an expensive proposition. It robs the dual citizen of tax deferral that he or she would otherwise enjoy. The high tax exclusion can be used to exclude the dividend, interest, and royalty income generated by a CCPC from Subpart F classification. It is unlikely that capital gain income is excludable because the Canadian tax rate will not be high enough and it is generally not possible to overpay the Canadian tax. Careful planning to maintain the Canadian corporate tax rate above 31.5% is required or else the strategy will be unsuccessful. Similarly, careful management of the RDTOH credits is required or else the strategy will result in an overpayment of total tax. However, with the caveats, some of the worst effects of the Subpart F regime can be mitigated. Notes: 1 Max Reed is a US and Canadian tax lawyer at SKL Tax, a boutique US and Canadian tax advisory firm in Vancouver, Canada ( Prior to joining SKL, he was a US tax lawyer at White & Case in New York and clerked for Justice Karen Sharlow of the Canadian Federal Court of Appeal, where he focused on Canadian tax law. He holds a BA and two law degrees from McGill University. He can be reached at [email protected]. 2 Code section 957(a). 3 United States Internal Revenue Code of 1986, as amended (the Code ). 4 Id. 5 Code section 951(b). 6 Code section Code section 954(a). 8 Dividend, interest, rents, and royalty payments received by a CFC from a related CFC (one that owns 50% or more of stock by vote or value), provided that the payments are attributable and allocable to neither Subpart F income nor income that is effectively connected to a US trade or business, are excluded from foreign personal holding company income (and, therefore, foreign base company income). Code section 954(c)(6); Treas. Reg (f). 9 Code section 954(c). 10 Code section 954(d). 11 Code section 954(e). 12 Income Tax Act (R.S.C., 1985, c. 1 (5th Supp.)) at s. 129(3). 13 This section is based on: Sun Life, What is Refundable Dividend Tax on Hand, Advisor Notes, July 2012, available online at: index.jsp?vgnextoid=d30a25c69f598310vgnvcm d2d09frcrd&vgnextfmt=default&vgnlocale=en_ca. 14 Stuart Hoegner, Refundable Dividend Tax on Hand and the Dividend Refund, Canadian Tax Journal, (2004), Vol. 52, No Code section 954(b)(4). 16 Reg (c)(1)(iii). 17 Reg (c)(1)(iii)(B). 18 Reg (c)(3)(iv). 19 Reg (d)(1). 20 Code section 954(c). 21 Reg (e)(2)(i).

5 TAX TOPICS 5 RECENT CASES CRA not entitled to notice of rectification order as its interests were not affected The applicant, the CRA (referred to in the decision as the CCRA ), was moving to set aside an order of Justice McLean, dated November 26, 2010, that ordered rectification of the taxpayers trust agreement, on the grounds that it should have been given notice of the rectification proceedings. The trust agreement had been executed in March 2004, and in March 2010 the trustees became aware that the lawyer who prepared the trust agreement made an error that prevented the distribution of trust property to intended minor beneficiaries. To correct this oversight, a rectification order was sought and the taxpayers were given advice by their tax advisers that the CRA need not be given notice of the application. Justice McLean granted the application for rectification and was aware that the CRA had not been served. While conducting an audit of a sale of a business related to the trust which took place before the rectification order, the CRA became aware of the rectification order in July Its motion to set aside the order was brought in May The taxpayers argued that there was no need to serve the CRA and that the application to set aside the rectification order was not brought forthwith. The motion to set aside the rectification order was dismissed. For the order to be set aside, the applicant must be a party affected by the order and the order must be brought forthwith. Being affected involves a proprietary or economic interest. The CRA argued it was affected because the rectification order reduced the tax payable to the CRA. At the time of the order, the CRA had no such interest. There was no tax liability established at the time of the sale of the business. Any liability was only to be determined after the filing of tax returns, which would take place sometime after the rectification order. The CRA would have been entitled to participate in rectification proceedings if it had been a creditor at the time of the proceedings, which was not the case here. The CRA also failed to bring the motion in a timely fashion. It argued that it was not aware until March 2013 that it had not been given notice due to the auditor not being familiar with rectification proceedings. Any ignorance on the part of the auditor is not a valid reason for delay, and there was no explanation given for the further two-month delay until it brought its application in May The legal interests of the CRA were not directly affected at the time of the order and, as such, there was no reason to give it notice of the proceedings. 48,950, Brogan Family Trust, 2015 DTC 5008 No foreign exchange gains realized on conversion of shares of convertible debentures The taxpayer was assessed for 2005 and 2006 on the basis that it realized deemed capital gains in the amount of $4,499,360 and $57,676,430 under subsection 39(2) of the Income Tax Act (the Act ) on the conversion of US-denominated convertible debentures to its common shares. The taxpayer argued that no foreign exchange gains were realized, because it had borrowed far less than it paid out in Canadian dollar terms and a conversion was a non-taxable event. The taxpayer s appeal was allowed. The convertible debentures were on capital account, and any gains realized would be a capital gain under subsection 39(2) of the Act due to the foreign currency fluctuation. In the case of the conversion of debentures for common shares in the taxpayer, the amount paid and extinguished for each debenture/ share was $1,000. Even when translated into Canadian dollars, the amounts were equal and no gain accrued to the taxpayer. 48,951, Agnico-Eagle Mines Limited, 2015 DTC 1008 Shortest distance from home to work to be used when determining qualification for eligible relocation The taxpayer moved from her home in Cochrane to Calgary, Alberta, and in 2012, she claimed moving expenses of $17,000 in respect of an eligible relocation (defined in subsection 248(1) of the Income Tax Act (the Act )). That provision requires that the new location place her at least 40 kilometres closer to the new location than the old home. The distance between the new home and the work location was 15 kilometres. The dispute centred on the distance

6 TAX TOPICS 6 between the old home and the new work location. The taxpayer argued it was 60 kilometres, whereas the Minister argued it was 40 kilometres when using a major urban road, which would mean that the new home was only 25 kilometres closer to the new work location. The taxpayer argued that the major route was under heavy construction and not the quickest route. The taxpayer s appeal was dismissed. The distance must be determined by the shortest route that one might travel to work, as long as it is a normal route used by the travelling public. In this case, the urban route was clearly a shorter route and a commonly used one. 48,953, Hauser, 2015 DTC 1011 TAX TOPICS Published weekly by Wolters Kluwer Limited. For subscription information, see your Wolters Kluwer Account Manager or call or (416) (Toronto). For Wolters Kluwer Limited Tara Isard, Senior Manager, Content Natasha Menon, Senior Research Product Manager Tax & Accounting Canada Tax & Accounting Canada (416) ext (416) ext [email protected] [email protected] Notice: Readers are urged to consult their professional advisers prior to acting on the basis of material in Tax Topics. Wolters Kluwer Limited Sheppard Avenue East PUBLICATIONS MAIL AGREEMENT NO RETURN UNDELIVERABLE CANADIAN ADDRESSES TO CIRCULATION DEPT. Toronto ON M2N 6X MAIN ST TORONTO ON M5W 1A tel [email protected] fax 2015, Wolters Kluwer Limited Tax Topics is a registered trademark of Wolters Kluwer Limited. CTOP