Canada's foreign investment entity rules: what tax executives need to know.

• Author: Thompson, Simon

On October 11, 2002, the Canadian Department of Finance released a third draft of complex tax legislation on the treatment of direct or indirect investments in foreign entities by Canadian taxpayers (the FIE Rules). (1) This article provides an overview of the FIE Rules and addresses the issues that tax executives should consider in managing risks associated with their application. Complicating this task is the high likelihood that significant technical changes may be made before the FIE Rules are passed into law. It is anticipated that the FIE Rules will be passed into law later this year, and will apply retroactively from January 1, 2003.

1. BACKGROUND

   For many years, the Canadian government has attempted to prevent Canadian investors from arranging to earn "passive" income outside Canada to achieve Canadian tax savings. The Canadian Income Tax Act (Canada) (the Act) addresses this concern primarily through two anti-deferral regimes: (2) the foreign accrual property income (FAPI) rules, (3) and the offshore investment fund property (OIFP) (4) rules.

   The FIE Rules will replace the OIFP rules and will backstop the FAPI rules (which only prevent deferral in respect of controlled foreign affiliates (CFAs)). (5) Although each of these regimes differ significantly from their equivalent regimes in the United States under the Internal Revenue Code (the Code), the FAPI and FIE/OIFP rules have the same general tax policy objectives as the Subpart F and passive foreign investment company (PFIC) rules, respectively.

2. FIE RULES

   The FIE Rules substantially extend the OIFP rules, raising numerous policy and administrative concerns, as highlighted below.

   1. Basic Charging Rule

      Subject to the application of an anti-avoidance rule for "tracking interests" (discussed below) and "foreign insurance policies," the FIE Rules apply to a Canadian taxpayer holding a "participating interest" in a "non-resident entity" (NRE) where: (6)

      * the taxpayer is not an "exempt taxpayer";

      * the NRE is a "foreign investment entity" (FIE); and

      * the participating interest is not an "exempt interest."

      Where these conditions are all met, the Canadian taxpayer must include a specified return in computing income equal to a prescribed interest rate multiplied by the "designated cost" of the participating interest. (7) Subject to certain transitional rules, the "designated cost" will generally be equal to the sum of the participating interest's cost and past amounts included in income under the FIE Rules in respect of the participating interest. If a participating interest has a "readily obtainable fair market value," (8) the Canadian taxpayer may elect that the prescribed rate regime not apply, in which case annual post-2002 accrued gains (and accrued losses) (9) would be recognized on an annual basis. (10) For property acquired after 2002, the mark-to-market election must be made with regard to the first year in which a participating interest is acquired. (11)

      The FIE Rules may also result in FAPI to a CFA of a Canadian taxpayer, since a CFA is deemed to be a Canadian taxpayer for purposes of applying the FIE Rules.

   2. Analysis of the Basic Charging Rule

      1. Participating Interest

         A "participating interest" represents an equity interest in a corporation, trust, partnership, or other entity. It also includes an option to acquire such an equity interest and property convertible into such an equity interest. A participating interest does not include a debt or a derivative contract, unless the contract can be settled through the delivery of a participating interest in an NRE.

      2. Non-Resident Entity (NRE)

         An NRE includes a corporation (12) or a trust (13) that is not resident in Canada for purposes of the Act. An NRE also includes a partnership or other organization, generally when they are formed under foreign laws. A FIE, however, does not include a partnership.

      3. Exempt Taxpayer

         There are two classes of "exempt taxpayers" excluded from the FIE Rules: recent immigrants to Canada (resident in Canada for up to 60 months) and most persons (such as trusts governed by pension plans registered under the Act) expressly exempt from Part I tax. (14)

      4. FIE

         An NRE is generally considered to be a FIE (15) at a particular time unless either of the following tests is satisfied:

         * the carrying value of the NRE's "investment property" is not greater than 50 percent of the carrying value of all its properties (referred to below as the "50-percent investment property test"), or

         * the NRE's principal business is not an "investment business."

         As a result of the complexity and the form of the FIE Rules and scarcity of information, many Canadian taxpayers (particularly investors holding minority interests) will likely make investments in NREs without knowing (or being in a position to demonstrate, if challenged) whether or not the NRE is a FIE. In addition, avoiding the application of the FIE Rules may be difficult since the Canada Customs and Revenue Agency (the CCRA) is authorized to demand information (in addition to their normal powers of reassessment) from a Canadian taxpayer requiring the taxpayer to demonstrate to the CCRA's satisfaction that an NRE is not a FIE. (16) If the Canadian taxpayer does not provide the requested information within 60 days (or a longer period acceptable to the CCRA), the NRE is deemed to be a FIE. Several other elements of the FIE Rules contain similar administrative overrides that potentially expand the application of the FIE Rules where requested information is not provided in a timely manner to the CCRA.

         (a) 50-Percent Investment Property Test

         "Investment property" of an NRE generally includes passive assets, such as shares, debt, and real estate. Exclusions (17) from "investment property" include:

         * property used or held in a business (other than an investment business, as described below), (18)

         * certain debt between affiliated corporations, the income from which would be characterized as active business income for FAPI purposes, (19)

         * certain property accumulated for a temporary period (generally up to 36 months) for the purpose of a qualifying active use, (20) and

         * shares and debt issued by "qualifying entities" (described below) in which the NRE has a minimum 25-percent interest. (21)

         The "carrying value" of an NRE's property is generally the amount at which the property is valued on a balance sheet prepared in accordance with permissible generally accepted accounting principles (GAAP). (22) A Canadian taxpayer can elect to value property of an NRE at its fair market value, as long as the property is so valued on the NRE's balance sheet.

         Consolidated financial statements (23) must be used in determining whether or not the 50-percent investment property test is satisfied, unless the taxpayer elects to use unconsolidated financial statements (the Unconsolidated Election). In either case, the general intent of the FIE Rules is to ignore shares and debt owned by an NRE in its affiliates for purposes of the 50-percent investment property test, and to deem the NRE to own a proportional amount of the affiliates' assets. (24) If consolidated financial statements are used, the NRE's affiliates are considered to be those entities whose assets are reflected in the consolidated statements (25) and the specified proportionality is based on the NRE's proportional interest in the retained earnings (and income) of each affiliate. (26) If the Unconsolidated Election is made, the NRE's affiliates are considered to be those entities linked by minimum 25-percent direct or indirect interests. (27)

         Significant problems may arise in applying these constructive ownership or look-through rules. We understand that an NRE's consolidated balance sheet would typically not reflect any proportionate interest in assets of its affiliates. Rather, consolidation would likely result in an NRE effectively being shown as owning 100 percent of the assets of its affiliates, with an entry on the liability side of its consolidated balance sheet reflecting minority interests in its affiliates. While the Unconsolidated Election could be made and the look-through rule in draft paragraph 94.1(2)(j) applied, that rule requires a great deal of information (28) about the assets and activities of entities in which the NRE may only have a minority interest. (29)

         In addition, information on financial statements often may not be specific enough to determine whether an asset is "investment property" for the purposes of the FIE Rules. Consequently, except in rare cases, it will be difficult to rely solely upon financial statements for determining whether or not the 50-percent investment property test has been met.

         (b) Investment Business Test

         As previously noted, an NRE will not be a FIE if its principal business is not an "investment business."

         An "investment business" is a business (other than an "exempt business") the principal purpose of which is to earn income from property, income from the insurance or reinsurance of risks, income from the factoring of trade receivables, or profits from the disposition of "investment property" (as previously described, except that the first three exclusions do not apply in this case).

         An "exempt business" is the business of certain regulated financial institutions, traders, and dealers and certain businesses involving the active management of investment property (e.g., rental of real estate, essentially where services in respect of the real estate are provided by employees of the NRE or related entities). Whether or not an NRE's principal business is an investment business depends on all the facts and circumstances, though the look-through rules used for the 50-percent investment property test apply in a similar manner in connection with determining whether or not an NRE's principal business is an investment business. (30)

      5. Exempt Interest

         The FIE Rules do not apply to an interest in a FIE that is an "exempt interest." There are...