Proposed amendments to the foreign affiliate rules

Introduction

On August 9, 2022, the Department of Finance (“Finance”) released details of proposed changes to the Income Tax Act (the “ITA”). A number of the proposed changes impact the rules relating to “foreign affiliates” as defined by the ITA. The most significant proposed changes are summarized below.

1. Expansion of anti-avoidance rules for foreign affiliate share exchanges and foreign mergers

Finance has proposed amendments to the anti-avoidance rule in subsection 85.1(4) of the ITA in respect of foreign affiliate share-for-share exchanges, and amendments to the anti-avoidance rule in subsection 87(8.3) in respect of foreign mergers.

In general, subsection 85.1(3) of the ITA permits a taxpayer to transfer shares of one foreign affiliate (a “subject affiliate”) to another foreign affiliate (an “acquiring affiliate”) on a tax-deferred “rollover” basis, provided the taxpayer receives at least one share of the acquiring affiliate.

Currently, paragraph 85.1(4)(a) of the ITA provides that the tax-deferred “rollover” in subsection 85.1(3) is not available if:

1. all or substantially all of the subject affiliate’s property is “excluded property”; and
2. the share transfer is part of a transaction or series of transactions for the purpose of disposing of the shares of the subject affiliate to a person or partnership with whom the taxpayer deals at arm’s length, other than a foreign affiliate in respect of which the taxpayer has a “qualifying interest”.

Subsection 87(8) of the ITA generally provides for a tax-deferred “rollover” where, upon a “foreign merger,” shares of a “predecessor foreign corporation” held by a taxpayer are exchanged for or become shares of a “new foreign corporation” or the foreign parent corporation.

Currently, subsection 87(8.3) of the ITA provides that the tax-deferred “rollover” in subsection 87(8) will not apply if:

1. the “new foreign corporation” is a foreign affiliate of the taxpayer;
2. shares of the “new foreign corporation” are “excluded property” of another foreign affiliate of the taxpayer; and
3. the foreign merger is part of a transaction or series of transactions that includes a disposition of shares of the “new foreign corporation” or substituted property to:
   1. a person with whom the taxpayer was dealing with at arm’s length (other than a foreign affiliate in respect of which the taxpayer had a “qualifying interest”); or
   2. a partnership a member of which is a person described in (i) above.

Finance has proposed to expand the scope of subparagraphs 85.1(4)(a) and subsection 87(8.3) of the ITA as follows:

1. the rules are expanded to disallow the rollover if there is a subsequent disposition of the shares, or property that is substituted for the shares of the subject affiliate, or if there is a subsequent disposition of property that derives its value directly or indirectly from the shares of the subject affiliate or the “new foreign corporation”, as applicable, or substituted property;
2. the scope of impermissible subsequent acquirers is expanded to include non-arm’s length non-residents and partnerships, any member of which is an arm’s length person or a non-arm’s length non-resident;
3. the carve-out for subsequent acquirers that are foreign affiliates in respect of which the taxpayer has a “qualifying interest” is replaced with a more limited carve-out for foreign affiliates that are “controlled foreign affiliates” of the taxpayer for the purposes of section 17 of the ITA; and
4. the rules are expanded to disallow the rollover where, at the time of the subsequent disposition, the property disposed of is “excluded property”.

The proposed expansion of paragraph 85.1(4)(a) and subsection 87(8.3) of the ITA to include non-arm’s length non-residents within the scope of impermissible subsequent acquirers, and the narrowing of the carve-out to “controlled foreign affiliates” within the meaning of section 17 of the ITA is a significant change which could eliminate the availability of a tax-deferred “rollover” for foreign affiliate share exchanges and foreign mergers in circumstances where previously available.

If implemented, the proposed amendments will apply to transactions that occur on or after August 9, 2022.

2. Narrowing of foreign affiliate liquidation and dissolution suppression Election

Subsection 88(3) of the ITA establishes rules that apply on a liquidation and dissolution of a foreign affiliate (a “dissolving affiliate”) where a taxpayer receives property from the dissolving affiliate in respect of shares of the dissolving affiliate that are disposed of by the taxpayer on the liquidation and dissolution. The general rule is that property distributed by a dissolving affiliate is deemed to be disposed of by the dissolving affiliate and acquired by the taxpayer at fair market value, and shares of the dissolving affiliate are deemed to be disposed of by the taxpayer at fair market value (i.e., on a taxable basis).

Paragraph 88(3)(a) of the ITA permits a dissolving affiliate to transfer property to a taxpayer on a tax-deferred “rollover” basis where either:

1. the liquidation and dissolution of the dissolving affiliate is a “qualifying liquidation and dissolution” (a “QLAD”); or
2. the distributed property is a share of another foreign affiliate that was “excluded property”.

Current subsection 88(3.3) of the ITA permits a taxpayer to elect to reduce the amount at which distributed property is disposed of under subsection 88(3)(a) of the ITA where the distributed property is capital property of the dissolving affiliate and the liquidation and dissolution is a QLAD. The election permits a taxpayer to defer the realization of capital gains on the disposition of the dissolving affiliate’s shares until the taxpayer later disposes of the distributed property.

Finance has proposed to amend subsection 88(3.3) to restrict the availability of the suppression election to distributed property of a dissolving affiliate that is shares of another foreign affiliate. This proposed change represents a significant reduction in the utility of the subsection 88(3.3) election.

If implemented, the proposed amendment  will apply to transactions that occur on or after August 9, 2022.

3. Narrowing of exception for upstream loans from ordinary lending business – Paragraph 90(8)(b)

Subsections 90(6) to 90(15) of the ITA contain the so-called “upstream loan rules.” These rules require a taxpayer to include a “specified amount” in income with respect to certain loans owing by, or indebtedness of, a “specified debtor” in respect of the taxpayer to a foreign affiliate of the taxpayer (a “creditor affiliate”).

Current paragraph 90(8)(b) of the ITA provides an exception to the upstream loan rules for  trade accounts receivable that arose in the ordinary course of a creditor affiliate’s business, or loans made in the ordinary course of a creditor affiliate’s ordinary business of lending money (an “ordinary lending business”) if, at the time the indebtedness arose or the loan was made, bona fide arrangements were made for repayment of the indebtedness or loan within a reasonable time.

Finance proposes to amend paragraph 90(8)(b) of the ITA to exclude from this exception any ordinary lending business where less than 90% of outstanding loans are owed by arm’s length borrowers. The effect of this proposed amendment is to eliminate the exception from the upstream loan rules for internal or “captive” lenders within a corporate group. The proposed change to paragraph 90(8)(b) mirrors the proposed change to subsection 15(2.3) of the ITA in respect of shareholder loans. For further details, please refer to our update: Release of draft Canadian tax legislation.

If implemented, these proposed amendments will apply to loans made on or after January 1, 2023 and the portion of any loans made before 2023 that remain outstanding on January 1, 2023.

4. Addition of tracking interest rules for umbrella trusts

Section 94.2 of the ITA establishes rules applicable to a taxpayer’s interest in certain non-resident commercial trusts. Where the requirements in subsection 94.2(1) are met, subsection 94.1(2) deems the non-resident commercial trust to be a non-resident corporation that is controlled by the taxpayer for the purposes of applying certain sections of the ITA.  As a result, any “foreign accrual property income” (“FAPI”) of the trust is attributed to and taxed in the hands of the taxpayer.

Finance has proposed to add a new subsection 94.2(5) to the ITA that would provide rules for attributing FAPI of a non-resident commercial trust that is subject to section 94.2 of the ITA where the trust is an “umbrella trust.” Generally, an “umbrella trust” is a single trust comprised of several sub-funds with segregated assets and liabilities. Beneficiaries of an umbrella trust generally hold interests in a particular sub-fund of the trust.

Where current subsection 94.2 of the ITA applies to a non-resident commercial trust, FAPI of the trust may be attributed to the taxpayer, even if the FAPI is not derived from the particular sub-fund in which the taxpayer is invested.

To address this mismatch, proposed subsection 94.2(5) extends the “tracking arrangement” rules in subsections 95(10) and 95(11) of the ITA to umbrella trusts subject to section 94.2 of the ITA. In effect, the proposed amendments deem the particular sub-fund in which the taxpayer is invested to be a “separate corporation” that is a controlled foreign affiliate of the taxpayer, so that only the FAPI that is based on the income, gains or losses realized in the particular sub-fund in which the taxpayer is invested are attributed to, and taxed in the hands of, the taxpayer.

If enacted these proposed amendments will apply to taxation years of trusts that begin after February 26, 2018.

5. Narrowing of base erosion rule for services income

Subparagraph 95(2)(b)(i) of the ITA deems certain income of a foreign affiliate to be income from a business other than an active business and therefore FAPI. Clause 95(2)(b)(i)(B) of the ITA applies where:

1. a foreign affiliate provides services (the “services affiliate”); and
2. amounts paid or payable to the services affiliate for the services are deductible in computing the FAPI of another foreign affiliate (the “payor affiliate”) of the taxpayer or another taxpayer that does not deal at arm’s length with the services affiliate or the taxpayer.

Presently, clause 95(2)(b)(i)(B) of the ITA deems all of the services affiliate’s service income from the payor affiliate to be FAPI, regardless of the proportionate interests of relevant taxpayers in the payor affiliate’s income.

To address this inappropriate result, Finance proposes to amend subsection 95(2)(b)(i)(B) of the ITA so that services income of a services affiliate from a payor affiliate is only deemed to be FAPI in proportion to the aggregate interests of relevant taxpayers in the payor affiliate.

The proposed amendment would apply in respect of taxation years of a foreign affiliate that begin after 2015.

Finance also proposes to add a new subsection 95(3.03) as an exception to subparagraph 95(2)(b)(i) of the ITA.

In general, proposed subsection 95(3.03) provides that subparagraph 95(2)(b)(i) of the ITA will not apply if the following conditions are met:

1. the taxpayer has a “qualifying interest” in the services affiliate or the services affiliate is a controlled foreign affiliate of the taxpayer;
2. the taxpayer has a “qualifying interest” in the payor affiliate;
3. the amounts paid or payable by the payor affiliate for the services are for expenditures incurred by the payor affiliate for the purpose of earning income from property;
4. the property of the payor affiliate referred to in (c) above is shares of another foreign affiliate of the taxpayer (the “third affiliate”) which are excluded property and the taxpayer has a “qualifying interest” in the third affiliate; and
5. either:
   1. the payor affiliate and/or the third affiliate are subject to income tax in a country other than Canada; or
   2. the members or shareholders of the payor affiliate and/or the third affiliate are subject to income tax in a country other than Canada on, in aggregate, all or substantially all of the income of the payor affiliate and/or the third affiliate (as applicable).

Proposed subsection 95(3.03) ensures that subparagraph 95(2)(b)(i) would not apply where the payor affiliate’s income is from shares of the third affiliate that carries on an active business. This is an appropriate result as subparagraph 95(2)(b)(i) would not apply if the services had been provided by the services affiliate directly to the third affiliate.

Proposed subsection 95(3.03), if enacted, applies for taxation years of a foreign affiliate that end after 2016.

6. Other proposed changes to the foreign affiliate rules

The proposed amendments contemplate a number of additional changes to the foreign affiliate rules, including:

• amendments to the foreign affiliate dumping rules to limit the reinstatement of paid-up capital (“PUC”) under subparagraph 212.3(9)(b) of the ITA in certain circumstances;
• amendments to the definition of “specified Canadian entity” in subsection 233.3(1) of the ITA to exclude certain partnerships from being required to file T1134 information returns; and
• the expansion of the special regime in section 93.3 of the ITA for Australian-resident trusts to include trusts resident in India which meet the other conditions in subsection 93.3(2).

Conclusion

If you would like more information regarding the August 2022 proposed changes to the foreign affiliate rules in the ITA, please contact a member of the Miller Thomson LLP tax team.