The fourth draft of the foreign investment entity legislation (FIE legislation) was released by the Canadian Department of Finance on October 30 2003 and generally adheres to the structure of earlier drafts. Certain major changes, and a host of technical revisions, have been adopted. The FIE legislation is to be effective for taxation years beginning after 2002.
The purpose of the FIE legislation is to prevent Canadian taxpayers from deferring Canadian tax on passive income by investing indirectly through offshore entities. It applies to a Canadian resident taxpayer who holds a participating interest in a foreign investment entity (a FIE) where the interest is not an exempt interest and the taxpayer is not an exempt taxpayer. The basic FIE regime now takes precedence over the tracking interest rules.
Where the FIE legislation applies, the taxpayer must include certain amounts in income as determined under one of three regimes:
l prescribed rate regime;
l mark-to-market regime; or
l modified accrual regime.
The latter two regimes are elective if certain conditions are satisfied.
A participating interest includes a share of a corporation, an interest in any other non-resident entity and a right to acquire any such property, or property (other than money) that derives its value from such property.
The FIE definition creates an exemption from the rules. Generally speaking, a FIE is any non-resident corporation, trust or other entity. However, an entity is not a FIE if the principal undertaking of the entity is the carrying on of a business other than an investment business or if the carrying value of its investment property is not greater than 50% of the carrying value of all its property. An investment business includes a business, the principal purpose of which is to derive income from property. Investment property includes shares, debt, realty, and derivatives but excludes property used or held principally in a non-investment business. The carrying value of investment property is its financial statement book value or, if elected, its fair-market value. Property that is not valued on the financial statements (for example, non-purchased goodwill) continues to be ignored for this purpose. Consolidated financial statements are used. However, taxpayers may elect to use non-consolidated financial statements in which event they can elect to use a look-through rule to deem assets of lower tier entities to be assets of the particular entity in certain circumstances.
The FIE legislation retains provisions pursuant to which an entity may be deemed to be a FIE if certain information is not supplied to the minister.
Exempt interests are not subject to the FIE legislation and include:
l controlled foreign affiliate corporations and certain foreign affiliates;
l interests held by financial institutions subject to mark-to-market rules;
l employment-related interests; and
l publicly held interests.
The last category is particularly important and reflects changes from earlier drafts of the FIE legislation. It applies where:
l the taxpayer has no tax avoidance motive;
l interests in the FIE may be bought and sold by members of the public in the open market (the interests are no longer required to be qualified for distribution to the general public, which created a concern that securities sold under prospectus exemptions would not meet the condition);
l certain minimum distribution thresholds are met;
l the interest held by the taxpayer is not a significant interest; and
l either: (a) the FIE is resident in a country which has a prescribed stock exchange and identical interests are listed on a prescribed stock exchange; or (b) the FIE exists under, is governed by and is resident in (for purposes of the treaty) a country which has a tax treaty with Canada.
The FIE legislation now requires that tax avoidance be determined with reference to acquiring, having or holding the interest.
Provisions of the FIE legislation designed to avoid double taxation have been substantially revised. If the prescribed rate regime over-accrues the actual increase in value of the interest in the FIE, the over-accrual may generally be deducted from the income account on the disposition of the interest, avoiding the former mismatch between an income inclusion and a capital loss. A foreign tax credit may now be claimed for withholding tax instead of a grossed-up deduction. Lastly, the deductions in respect of dividends from foreign affiliates do not reduce the deductions under the FIE legislation for taxpayers who are under the prescribed rate or the mark-to-market regimes.
The FIE legislation also contains rules applicable to non-resident trusts under which certain of such trusts may be deemed to be residents of Canada, but it is intended that bona fide commercial investment trusts be exempt from those rules and treated as FIEs.
It remains to be seen whether the FIE legislation will become law in its current form or will be further deferred.
Patrick McCay (PMcCay@mccarthy.ca), Toronto
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