“The draft proposals follow on and in some cases significantly expand proposals first put forward in the March federal budget,” said Ian Crosbie, partner at Davies Ward Phillips & Vineberg. “Principally they relate to anti-avoidance rules regarding sales of partnership interests, changes to the Canadian thin-capitalisation rules and foreign affiliate dumping rules, as well as changes to certain rules relating to scientific research and experimental development tax incentives.”
While the proposals seek to implement several measures announced in the March budget, the international tax measures also included can generally be viewed as part of the government’s response to the 2008 Report of the Advisory Panel on Canada’s System of International Taxation.
“Perhaps the biggest news in the March budget was the new proposal to treat investments in foreign affiliates by foreign-controlled Canadian corporations as deemed dividends,” said Jeffrey Trossman, partner at Blake, Cassels & Graydon. “These new measures seek to deter Canadian subsidiaries of foreign multinationals from either contributing cash to, or acquiring, foreign subsidiaries, thereby reducing the likelihood of erosion of the Canadian tax base.”
One of the main aims of the legislation is to prevent the avoidance of corporate tax through the use of partnerships to convert income gains into capital gains.
“The partnership transactions these rules are aimed at essentially involve transferring assets that would have a fully taxable gain on disposition into a partnership on a rollover basis and then selling the partnership interest so that the vendor realises a capital gain,” said Crosbie.
The March budget expanded a rule to deny the seller the favourable tax rate (half the normal tax rate) for the capital gain, and these proposals expand it even further to include new anti-avoidance rules.
The draft legislation also modifies the March budget proposal in certain respects to mitigate some of the unintended consequences of the original, Trossman points out.
It does this by allowing the immediate deemed dividend to be avoided by electing that the amount of the investment be applied to reduce cross-border paid-up capital (PUC).
“While the PUC suppression rule is welcome, it is drafted quite narrowly, so considerable attention to detail will be required,” said Trossman.
It also modifies the original proposal by allowing a subsequent PUC reinstatement where there was a previous PUC suppression.
“This effectively allows a Canadian company to be used as a conduit for holding foreign investments as long as there is no Canadian base erosion,” said Trossman.
A third way it modifies the original is by allowing the Canadian company to invest in foreign subsidiaries by making loans that carry at least a baseline interest rate (the greater of a prescribed rate and the borrowing costs associated with the invested cash).
“This welcome rule allows Canadian subsidiaries of foreign multinationals to continue to fund other foreign subsidiaries as long as they do so by way of interest-bearing loans. One important detail is that the prescribed rate is a rate that floats from time to time and is essentially the short-term government treasury bill rate plus 4%,” said Trossman.
Finally, modifications are also made by exempting from the rules certain types of reorganisation transactions that were caught by the initial proposal.
Crosbie said there is no particular motivating factor for this rule against the use of partnerships coming now.
“But it is true that tax revenues are at a premium these days as Canada seeks to climb back out of deficit without rate increases (even if our deficit is mild by international standards and growth prospects relatively healthy), and thus tightening of screws generally can be expected,” he said.
The existing rule was somewhat incomplete, Crosbie says, and this proposal represents a “more comprehensive approach to the issue” and “makes more sense from a tax policy perspective”. While it was not expected, Crosbie says it has not been met with outrage, but that “the long-standing misalignment of the rule and its purpose make it hard to consider this an appropriate legislative response”.
Trossman is worried that the foreign affiliate dumping rules have been drafted too broadly, and that they might deter taxpayers from engaging in perfectly legitimate transactions that do not erode the Canadian tax base.
“The government has made some efforts to narrow the rules, but I still believe more could be done to better target the measure at the perceived tax avoidance transactions meant to be deterred,” he said.
The government is now welcoming comments on the proposals, with a view to implementing them shortly after.
“The government has solicited comments from interested parties by September 13 2012 and then, subject to any changes arising from those comments, is likely to introduce these measures into parliament in the autumn session,” said Trossman.
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