Canada's new foreign investment entity rules.

• Author: Thompson, Simon

On October 30, 2003, the Canadian Department of Finance released a fourth draft of complex tax legislation on the treatment of direct or indirect investments in foreign entities by Canadian taxpayers (FIE Rules). (1) This article updates an article on the third version of the FIE Rules, (2) providing an overview of the revised FIE Rules and issues that tax executives should consider. It is anticipated that the FIE Rules will be passed into law later this year, and will apply retroactively from January 1, 2003.

The Income Tax Act (Canada) (the Act) (3) contains two primary anti-deferral regimes to prevent Canadian taxpayers from earning "passive" income offshore: the foreign accrual property income (FAPI) rules, (4) and the FIE Rules, which replace and significantly expand the offshore investment fund property (OIFP) (5) rules.

The FIE Rules backstop the FAPI rules, which prevent deferral in respect of controlled foreign affiliates (CFAs). (6) Although each of these regimes differ significantly from their parallel regimes in the United States under the Internal Revenue Code (the U.S. Code), the FAPI rules and the FIE Rules have the same general tax policy objectives as the Subpart F and passive foreign investment company (PFIC) rules, respectively.

FIE Rules

1. Basic Charging Rule

   Subject to the application of special rules for "tracking interests" and "foreign insurance policies," the FIE Rules apply to a Canadian taxpayer holding a "participating interest" in a "non-resident entity" (NRE) in a particular taxation year of the Canadian taxpayer where: (7)

   * the taxpayer is not an "exempt taxpayer" for the particular year;

   * the taxpayer holds the interest in the NRE at the end of a taxation year of the NRE that ends in the particular year;

   * the NRE is a "foreign investment entity" (FIE) at the end of the NRE's taxation year; and

   * the participating interest is not an "exempt interest" at the end of the NRE's taxation year.

   If these conditions are all met, the Canadian taxpayer must generally include a specified return in computing income equal to a prescribed interest rate multiplied by the "designated cost" of the participating interest. (8) Subject to certain transitional rules, the "designated cost" will generally be equal to the sure of the participating interest's cost and past amounts included in income under the FIE Rules in respect of the participating interest. If certain conditions are satisfied, the Canadian taxpayer may elect to apply either a mark-to-market regime (9) or an accrual regime rather than the prescribed interest rate regime. The election to apply either the mark-to-market or the accrual regime must be made in respect of the first year in which the FIE Rules will apply (2003, or the first year in which the participating interest is acquired). (10) New rules have been added to prevent many tax-deferred transfers of participating interests in a FIE (other than exempt interests). This prohibition is primarily meant to prevent taxpayers from minimizing the effect of the prescribed interest rate regime, for example, by transferring a participating interest in an NRE shortly before the NRE's year end to a non-arm's length transferee. (11)

   The FIE Rules may also result in FAPI to a CFA of a Canadian taxpayer, as 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" is an equity interest in a corporation, trust, partnership or other entity, an option to acquire such an equity interest, or property convertible into such an equity interest. (12) 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. A new exemption explicitly excludes cash settled derivative contracts. (13)

   2. Non-Resident Entity

      An NRE means a corporation or a trust that is not resident in Canada for purposes of the Act, (14) or any other entity (such as a partnership) formed or governed under foreign laws. An interest in a partnership, however, is an "exempt interest."

   3. Exempt Taxpayer

      There are generally three classes of "exempt taxpayers" excluded from the FIE Rules: recent immigrants to Canada (resident in Canada for up to 60 months), most registered pension plans (15) and other persons exempt from Part I tax, (16) and certain Canadian resident trusts in which each beneficiary is exempt from tax. (17)

   4. FIE

      An NRE is generally considered to be a FIE (18) at the end of a taxation year of the NRE unless either of the following tests is satisfied:

      * the carrying value of the NRE's "investment property" is hot greater than 50 percent of the carrying value of all its properties at the end of the year (the "50-percent investment property test"); or

      * the NRE's principal undertaking, throughout the year, is the carrying on of a business that is not an "investment business."

      Because a determination of FIE status is not made until the end of a NRE's year end, it is impossible to predict with certainty at the time a participating interest in the NRE is acquired whether the NRE will be a FIE. This uncertainty makes it impossible to know whether various rollover rules would apply on transfers of an interest in an NRE (as a rollover may be denied if the NRE is a FIE at year end, even if it would not otherwise have been a FIE at the time of the transfer). Also, as a result of the complexity and form of the FIE Rules and the scarcity of information, many Canadian taxpayers (particularly investors holding minority interests) will be unable to determine (even after a year end of an NRE) whether the NRE is a FIE. In addition, avoiding the application of the FIE Rules may be difficult as the Canada Revenue Agency (CRA) is authorized to demand information (in addition to their normal powers of reassessment) from a Canadian taxpayer requiring the taxpayer to demonstrate to the CRA's satisfaction that an NRE is not a FIE. (19) If the Canadian taxpayer does not provide the requested information within 60 days (or a longer period acceptable to the CRA), the NRE is deemed to be a FIE. The FIE Rules contain several similar administrative overrides that potentially expand the application of the FIE Rules where requested information is hot provided in a timely manner to the CRA.

      (a) 50-Percent Investment Property Test. "Investment property" of an NRE includes most passive assets such as shares, debt, real estate, resource property, currency, and derivative financial products. "Investment property," however, does not include:

      * property used or held in a business (other than an investment business, as described below); (20)

      * certain debt between affiliated corporations, the income from which would be characterized as active business income for FAPI purposes; (21)

      * certain property accumulated for a temporary period (generally up to 36 months) for the purpose of a qualifying active use; (22)

      * shares issued by the NRE itself; (23) and

      * shares and debt issued by "qualifying entities" (described below) in which the NRE has a minimum 25-percent interest. (24)

      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). (25) A Canadian taxpayer can elect to value property of an NRE at its fair market value, provided the property is on the NRE's balance sheet (e.g., purchased goodwill, but not unpurchased goodwill).

      Presumably, consolidated financial statements must be used in determining whether the 50-percent investment property test is satisfied, unless the taxpayer elects to use unconsolidated financial statements (the "Unconsolidated Election"). (26) The general intent of the FIE Rules is to ignore shares and debt owned by an NRE in its affiliates that are not included in its consolidated financial statements for purposes of the 50-percent investment property test. The NRE is considered to own properties owned by affiliates that are included in a consolidated financial statements. (27) In addition, an election may be made to deem an NRE to own a proportionate amount of an affiliate's assets (rather than a participating interest in an affiliate) if the NRE has a direct or indirect significant interest (28) in the affiliate and, if the Unconsolidated Election is hot made, the affiliate is not included in the NRE's consolidated financial statements. (29)

      Unfortunately, information on financial statements often may hot be specific enough to determine whether an asset is "investment property" for the purposes of the FIE Rules. Consequently, it will often be difficult to rely solely upon financial statements for determining whether the 50-percent investment property test has been met.

      (b) Investment Business Test. An NRE will not be a FIE if its principal undertaking is the carrying on of a business that is not an "investment business" throughout the NRE's taxation year.

      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" (except that the first three exclusions described above do not apply in this case).

      An "exempt business" is the business of certain regulated financial institutions, regulated 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 an NRE's principal business is an investment business depends on the facts and circumstances, (30) though the look-through rule used for the 50-percent investment property test applies in a...