Revised Canadian proposals affecting foreign affiliates.

• Author: Slaats, Sandra

Overview

The Canadian Department of Finance released a revised package of technical amendments on February 27, 2004. The package is a revised version of the draft legislation originally released on December 20, 2002, and reflects consultations and discussions with taxpayers, as well as with professionals groups such as Tax Executives Institute and the Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants.

The draft legislation addresses a number of technical problems with the Income Tax Act that have accumulated during the last several years. Many of the proposed amendments to the foreign affiliate rules address problems with the legislation that was introduced in 1995, when the rules were last significantly amended. Many of the amendments implement changes of a relieving nature that were "promised" to tax payers or their representatives in a series of so-called comfort letters.

Significantly, however, the December 2002 draft legislation also contained proposals that were not expected, and threatened to adversely affect reorganizations of foreign affiliates occurring after that date. The February 2004 version of those particular proposals is much less negative, and thus is welcome. At the same time, the Department of Finance took the opportunity to revise almost every reorganization provision and to introduce several new rules, many of which are extremely complex and could have unforeseen consequences.

This article addresses the most significant provisions of the February 2004 draft legislation.

The Global Section 95 Election

If a taxpayer wishes to apply certain relieving changes retroactively to a taxation year commencing after 1994, an election may be available to do so. If the changes are part of the global section 95 election or "global election", however, then under the December 2002 draft legislation, making that election may cause other proposals to apply retroactively, which could have negative consequences for some taxpayers. The global election entails the retroactive application of a large number of the foreign affiliate amendments contained in the technical bill, many of which deal with completely unrelated issues. This aspect of the technical bill has been subject to much criticism.

In the February 2004 draft legislation, Finance responded to this criticism by "unbundling" some of the provisions from the global election and creating separate elections to apply those provisions retroactively.

The decision whether to make the election (or the unbundled elections) will still involve significant analysis. The election is required to be filed by the due date for the taxpayer's return that includes the date when the legislation receives Royal Assent. If a taxpayer chooses unwisely, the 2004 draft legislation provides a three-year window for the taxpayer to revoke the election retroactively.

Reorganizations and Other Transactions

Some of the 2002 proposed amendments to the foreign affiliate rules were unexpected and could have had a significant effect on common transactions. The following is a summary of those proposals and the other significant proposals affecting reorganizations.

1. Transfers of Foreign Affiliates Within an Arm's-Length Group. The first proposed change related to certain transfers of shares of a foreign affiliate to other foreign affiliates or certain non-arm's-length persons. In many cases, the proposal (in proposed subsection 93(1.4) of the Act) would have deemed the shares transferred to be outside the definition of"excluded property." Consequently, any gain realized by an affiliate on the disposition of the shares (in excess of the amount eligible for a section 93 deemed dividend election) would create foreign accrual property income (FAPI), which is taxed immediately in the hands of the Canadian shareholder if the affiliate is a controlled foreign affiliate. In addition, draft regulations released in 2002 would have restricted the amount of surplus eligible for the section 93 deemed dividend in these circumstances. Draft regulation 5902(7) would have prevented the taxpayer from accessing the surplus balances of lower-tier affiliates owned by the affiliate that was the subject of the disposition.

   According to the explanatory notes, the proposals were intended to prevent taxpayers from utilizing internal reorganizations to create additional surplus or an increase in the tax basis of shares in circumstances in which the shares transferred would continue to be part of the group and thus continue to have surplus balances in respect of the taxpayer or a non-arm's-length party. Unfortunately, however, the proposals had more severe consequences than required to achieve those objectives.

   There are many circumstances unrelated to Canadian taxation where it is necessary or advisable to transfer the ownership of foreign affiliates within a related group. After December 20, 2002, many taxpayers were forced to put such internal reorganizations on hold pending a determination of the effect of the new rules and a reconsideration of the draft legislation by the Department of Finance. Others were forced to proceed with transactions with very little information concerning the likely tax consequences.

   The February 2004 proposals provide that such transactions will not create FAPI unless the taxpayer so elects, which may be prudent if the transaction is taxable in the local jurisdiction and foreign taxes will offset the FAPI inclusion. Instead, the Department introduced complex surplus suspension rules in proposed new paragraphs 95(2)(c.1)--(c.6). Any gain on the sale of shares that are excluded property to a "specified purchaser" will be suspended until such time as the shares are disposed of by the specified...