Canadian International Tax Legislative Update Tax Executives Institute Dallas, Texas March 12, 2013 Dave Beaulne, CPA, CA KPMG LLP - Toronto

Canadian International Tax

Legislative Update

Tax Executives Institute

Dallas, Texas

March 12, 2013

Dave Beaulne, CPA, CA

KPMG LLP - Toronto

2© 2013 KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

Agenda

1. Background on Canadian tax

2. Inbound (investment into Canada) developments:

a) Pertinent loans or indebtedness (PLOIs)

b) Thin capitalization amendments

c) Foreign affiliate dumping

3. Transfer pricing

4. Outbound (Canadian investment abroad) developments

5. Tax treaty developments

1. Background on Canadian tax


Background on Canadian tax

Federal/provincial corporate tax rates

• Federal tax rate is 15%

• Provincial tax rates range from 10% to 16%, but the big 4 (B.C., Alta, Qc and Ont) are in the 10% to 12% range

PUC (paid-up capital)

• Distributions from a Canadian corporation to its foreign parent can be in the form of dividends (generally subject to 5% WHT) or a return of PUC (which is free of WHT)

Exemption system

• Dividends from a foreign subsidiary to its Canadian parent are generally exempt (no regard to level of foreign tax) if the income is from an active business carried on in a country with which Canada has an income tax convention (treaty) or a tax information exchange agreement (TIEA)



Interest expense

• No general restrictions on interest paid on borrowings used to acquire foreign subsidiaries (referred to as “foreign affiliates”), notwithstanding that income therefrom may be exempt

• Thin capitalization rules restrict interest expense solely based on identity of lender (generally related non-residents) and level of debt and equity in the company

Constructive dividends

• Loans by a Canadian subsidiary to its foreign parent (or non-resident persons related to the parent) are treated as constructive dividends (subject to 5% WHT) if left outstanding for, roughly, 1.5 years

• 5% WHT is refundable upon repayment, unless part of a series of loans and repayments

• Loans by a foreign subsidiary of a Canadian corporation (referred to as “upstream loans”) to the Canadian parent or a foreign grand-parent are also treated as constructive dividends in certain circumstances



Treaty policy

• Dividend WHT: 5% and 15%

• Interest WHT: 10% N-A-L; 0 A-L (under domestic law)

• one exception: U.S.

• Royalty WHT: 0 on patents and know how; 10% on others

Taxable Canadian property

• Non-residents of Canada taxable on gains only if TCP

• real estate and resource property

• shares that derive more than 50% of value from RE and RP

2. Inbound developments


Pertinent loans or indebtedness (PLOIs)

PLOIs

• HUGE relieving change for loans from a Canadian corporation to its foreign parent (or other related foreign persons)

• Provides an elective exclusion from the constructive dividend rules at the cost of imputed interest at a prescribed rate

USCo

Canco

Loan 1 Germany

Loan 2


PLOIs

Constructive dividend rules

• In the absence of a PLOI election, Loans 1 and 2 are deemed to be dividends paid to U.S. parent and German subsidiary, respectively, if they remain outstanding beyond the end of the taxation year following the year in which the loan is made (on average, 1.5 years)

• Dividend WHT of 5% on Loan 1 and 15% on Loan 2

• Upon repayment of the loans, WHT is refundable, unless the repayment is part of a “series of loans and repayments”

PLOI election

• Constructive dividend rule N/A

• Canadian corporation must include interest of at least a prescribed rate in its income

• Currently the rate is approx. 5% (1% gov't bond rate plus 4%)

• Higher rate required if funding rule applies

• No refundability of taxes upon repayment

9


PLOIs

Conditions for application

• Loan must come from a Canadian corporation (CRIC)

• Loan must be received by a foreign corporation

• CRIC must be controlled by the borrower, or by a foreign corporation that is related to the borrower

• Loan must be made after March 28, 2012

• Election required, on a loan by loan basis, on or before CRIC’s FDD for year of loan (June 30th for a calendar year CRIC)

• Additional rules deal with partnerships, late-filed elections and mergers

10


PLOI – imputed interest

• Interest imputed to the extent prescribed rate exceeds actual interest rate

• example:

• prescribed rate is 5%;

• actual interest rate on loan is 2%;

• therefore, CRIC must include another 3% in income

• Creates an incentive to set actual rate equal to PR

• However, if interest is adjusted downward under competent authority request, PLOI election is invalidated

• If PLOI is funded by a borrowing by the CRIC and the rate on the borrowing is higher than PR, CRIC must include in income an amount equal to interest expense on borrowing

11


PLOI election – perspective

• Avoids WHT on constructive dividend

• But, not a permanent tax: WHT is refundable when loan is repaid

• total Canadian tax paid over time (under PLOI election) may well exceed 5% WHT on constructive dividend, and creates greater amount of cash “trapped” in Canada

• key is to recover the Canadian tax on PLOI with a deduction in the U.S.

• risk that PLOI rate is higher than arm’s length rate

• foreign revenue authority (IRS) could make transfer pricing downward adjustment on PLOI interest rate;

• can’t recover under MAP

12


PLOI election – transitional issues

• PLOI election applies to loans made after March 28, 2012

• What about loans made before?

• Can a refund of WHT be obtained for repayment of old loans, with PLOI rules applying to a new post-March 28th loan?

• Initial policy views from Canadian gov’t not favourable

• However, still a technical avenue:

• Constructive dividend rule has a “series of loans and repayments” prohibition

• Does a single repayment, followed by a new post-March 28th loan fall afoul?

• Representations continue to be made on this: stay tuned …

13


Thin Capitalization

• March 29, 2012 Budget made a number of changes

• Debt-to-equity ratio reduced to 1.5:1 (from 2:1)

• interest is denied to the extent the ratio is exceeded

• equity is R/E and cross-border PUC/contributed surplus

• debt is only that lent by specified NR (generally related NR)

• guaranteed debt and domestic tax exempts not included

• Denied interest now recharacterized as a dividend for WHT purposes

• thin cap results in permanent denial of interest: no c/fwds – thus, notionally treated as a dividend

• interest WHT was still levied on denied amounts

• Fifth Protocol with U.S. in 2007 eliminated (on a phased-in basis) interest WHT on related party interest – created a planning opportunity for denied interest

14


Thin Capitalization

• Thin capitalization rules now extended to partnerships that borrow from specified NRs (where partnership has Canadian-resident members)

• rule operates on a look-through basis: partnership’s debt allocated to its members based on its proportionate share of the income or loss of the partnership

• Relieving change made for loans from a foreign subsidiary to its Canadian parent

• in certain corporate structures “upstream loans” could cause double tax:

• interest paid by Canco denied under thin cap

• interest received by foreign sub included in Canco’s income under FAPI (CFC rules)

• new rule turns off thin cap to the extent of FAPI

15


Thin Capitalization

16


Evolution of the Foreign Affiliate Dumping rules

Interest deductibility

■ June 1971 Budget: removed the denial of interest to a Canadian corporation on funds borrowed to acquire shares of another corporation (domestic or foreign)

■ AG report in 1992 was critical of this policy re: FAs

■ 1997 Mintz Report recommended broad-based interest restrictions

■ AG report in 2002 reiterated its previous criticism, most particularly with respect to foreign-controlled Canadian companies

■ March 2007 Budget adopted, in most respects, the Mintz Report proposals

– interest on borrowed money used to acquire shares of FAs would be denied (unless and until taxable amounts were received)

■ Heavy backlash led to a watered-down proposal in May 2007 which targeted double dip interest – proposal was to be effective starting in 2012

– As part of the May 2007 proposals the Minister of Finance re-iterated his March 2007 proposal to create an Advisory Panel that would study, among other things, thin cap reform and “debt dumping”, which many said was the real problem with interest deductibility


Evolution of the Foreign Affiliate Dumping rules

Interest deductibility (cont’d)

■ December 2008 Advisory Panel issued its Final Report which recommended, among other things, the repeal of the “double dip” rule

■ January 2009 Budget took up the Panel’s recommendation and repealed the double dip rule (which wasn’t even in effect yet)

■ March 2012 Budget introduced Foreign Affiliate Dumping rules (and made some amendments to the thin cap rules)

– FA-D is a deemed dividend rule, not an interest denial rule, but one its key objectives is to deter “debt dumping”

– deemed dividend approach helps deal with “tracing” problems

– rules allow access to treaty-reduced dividend WHT rates, which allows cost to be reduced to 5% - thus, could still be worthwhile

– BUT: Budget comments contain a warning that if FA-D continues, additional steps could be taken


Foreign Affiliate Dumping – big picture

The perceived abuse

■ Foreign companies eroding the tax base by selling FAs to Canadian subs in exchange for debt – interest deductible but dividends exempt (debt dumping)

■ Foreign companies avoiding dividend WHT by having Canadian subs transfer excess cash through purchase of FAs - again, no likely taxation of the investment in the FA

– Both aspects use the FA exemption system to achieve Canadian tax benefits

Solution: deemed dividend to extent of purchase price

■ For WHT avoidance, puts taxpayers in same position

■ For "debt dumping", acts as a deterrent

– question as to whether 5% is enough to deter (AP didn’t think so)


New $10M Interest Bearing Debt

• US Parent contributes shares of UKCo to Canco in exchange for debt of $10M and $5M of Canco shares;

• Canco’s thin cap attributes (PUC) increase by $5M, which allows full interest deduction on increased debt of $10M (based on pre-2012 2 to 1 ratio);

• UKCo is now an FA of Canco, and dividends can be distributed to Canco tax free;

• alternatively, Canco could pay with excess cash, thereby avoiding 5% dividend WHT.

Equity $5M

FMV = $15M

US Parent

UK Co Canco

UKCo

20

Foreign Affiliate Dumping – targeted transactions


Foreign Affiliate Dumping – conditions

Conditions for application of rules

■ Canadian resident corporation (CRIC) is controlled by a non-resident corporation

■ CRIC makes an “investment” in a foreign affiliate (FA)

“Investment” includes

■ Acquisition of shares of FA (whether from A-L or N-A-L party)

■ Indirect acquisitions: acquisition of Canco if loaded with FAs (> 75%)

■ Loans from CRIC to FA

– Excludes certain debt arising in ordinary course of CRIC’s business

– Excludes “pertinent loans or indebtedness” (PLOIs)

■ Other variations: acquisition of debt, extension of maturity date, capital contributions


Foreign Affiliate Dumping – indirect acquisitions

Indirect investment in FA

■ Direct acquisition by CRIC of shares of a Canadian corporation that owns a FA

■ At least 75% of Canadian corporation’s value is attributable to FA shares

CanTarget

CanAcq CoCRIC =>

>75% of value


Foreign Affiliate Dumping – consequences

Results of application of FA-D rules

■ Deemed dividend equal to value of property transferred by CRIC, or debt assumed by CRIC, in respect of the investment in FA

– default rule: dividend deemed paid by CRIC to non-resident parent

– special rules facilitate access to 5% WHT rate

– dividend reduced to extent of CRIC’s cross-border PUC

Related rules

■ PUC suppression

■ Contributed surplus suppression

■ Immigration

■ Emigration


Foreign Affiliate Dumping – exceptions / relief

Closer connection exception

■ Business activities of FA must be more closely connected to business activities of CRIC than to business activities of other non-resident group members

■ Meant for CRICs that are acting like a true MNC, i.e. it would have made the purchase if it were not controlled by NR

“Pertinent loan or indebtedness” (PLOI) election

■ Generally results in imputed income inclusion equal to unrounded prescribed rate plus 4%

Certain reorganizations exempted

■ Internal reorganizations that could otherwise result in an acquisition of FA shares by a CRIC

PUC reinstatement

■ Allows unwind of FA investment where CRIC used as holding company


Foreign Affiliate Dumping – take aways

■ If Canco is controlled by a non-resident corporation, rules must be top-of-mind when Canco has existing investments in foreign affiliates or is contemplating a new FA acquisition

■ Be wary of transactions that routinely occur, such as cash movements in cash pooling arrangements that involve foreign affiliates and Canada

■ Reconsider cash management strategy where Canada accumulates excess cash which has historically been used to fund foreign affiliates

■ All is not lost – 5% toll charge may still lead to long term benefits (especially if interest rates rise)

– But, keep in mind government’s warning of possible future action


• Pre-FA Dumping, NewCanco could acquire shares of USco from US Parent in consideration for NewCanco shares with PUC of $100; USco would then liquidate

• FA Dumping now grinds PUC of NewCanco shares to nil (because purchase of USco is an investment in a FA made by a CRIC)

• Workarounds exist, but must consider GAAR

• Was this structure intended to be caught? What does the extrinsic evidence suggest?

PUC = $100

FMV = $100PUC = $1

US Parent

USco

Canco

NewCanco

USco

Canco

26

Foreign Affiliate Dumping – collateral damage?

3.Transfer pricing


Transfer pricing “primary” adjustments generally adjust income for incorrect pricing

Secondary adjustments are intended to account for the “excess” funds that have been transferred out of the Canadian tax system

Budget 2012 introduced specific legislation to codify CRA practice

deemed dividend to foreign person with which transaction carried out

clarifies which treaty to apply

where foreign person is not a shareholder, 5% WHT n/a

repatriation relief, but subject to discretion of CRA

no application to CFAs

Canco

Overpayment for purchases; underpayment for sales

Deemed dividend: to USCo or Forco?

Transfer pricing: secondary adjustments

4.Outbound developments


Outbound developments

TTAA / Bill C-48

■ very large tax bill

■ NWMM on October 24, 2012

■ November 21, 2012: first reading in the House of Commons

■ Part 1 deals with non-resident trusts and offshore investment funds

■ Part 2 covers the December 18, 2009 foreign affiliate proposals

■ Part 3 covers the August 19, 2011 foreign affiliate proposals (including hybrid surplus and upstream loans)

■ Part 5 includes the foreign tax credit generator rules and various long-outstanding technical amendments



Hybrid surplus

• new surplus account to ensure capital gains on dispositions of FA shares are properly taxed when any part of proceeds distributed to Canada

• also ensures no creation of phantom exempt surplus

• no new developments, but now fully phased-in (as of 2013)

Foreign tax credit generators

• hybrid instruments anti-avoidance rule

• denies FTC where Canada and foreign jurisdiction (most commonly U.S.) view investment differently (such as repos)

• in FA context, any FAPI earned in a chain of companies that has a hybrid instrument will not be eligible for FTC

• tainting was broader in pre-October 24, 2012 version of rules



Upstream loans

• ensures Canadian taxpayers cannot avoid dividend tax on distributions from FAs by instead having FAs make loans (where insufficient basis and exempt surplus)

• if loan not repaid within 2 years, full principal amount included in income

• deduction to the extent of repayment

• October 24, 2012 re-release provides some relief, including:

• pre-August 19, 2011 loans now have 5 year repayment deadline;

• FX gain/loss offset for pre-August 19th loans


• if Canco paid a dividend to USco, dividend would attract 5% Canadian dividend withholding tax;

• thus, Canco could form FA and contribute its excess cash to FA in exchange for stock;

•FA would then lend the cash to USco;

•low market rates meant that only 1% interest needed to be charged

•upstream loan rules require full principal amount to be included in Canco’s income (if not repaid within 2 years)

•new developments:

• pre-August 19, 2011 loans now have 5 years for repayment;

• FX gain/loss offset

• FA Dumping applies to new investments in FA by Canco

USCo

FA

Canco

Loan

Outbound developments – upstream loans example

5. Tax treaties


Tax treaty developments

Income Tax Treaties

• 90 in force

• Hong Kong, signed but not in force

• Canada-U.S. L.O.B. issues

• Recent treaties with anti-shopping clauses

Tax Information Exchange Agreements (TIEAs)

• Carrot and stick

• 16 in force; no expiries yet

• BVI has until end of 2013 to conclude

Thank you, gracias, merci!

Dave Beaulne CPA, CAOttawa (613) 212-3744Toronto (416) 777-3910e-mail: [email protected]

© 2013 KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International Cooperative (“KPMG International”).

Information current to February 28, 2013. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

Documents

Canadian International Tax Legislative Update Tax Executives Institute Dallas, Texas March 12, 2013 Dave Beaulne, CPA, CA KPMG LLP - Toronto