Tax Letters: 2016 Canadian Federal Budget – InternationalMarch, 2016
In the domestic context, section 84.1 is designed to prevent surplus stripping in non-arm’s-length situations. The following broad example illustrates this provision.
Assume that individual X, a Canadian resident, owns all of shares of Opco, a corporation resident in Canada, having an FMV of $100,000, an adjusted cost base (ACB) of $20,000 and paid-up capital (PUC) of $1.00. If X were to transfer the shares of Opco to a non-arm’s-length Holdco and did not wish to realize a taxable amount, X could receive non-share consideration with a maximum FMV of $20,000, being the greater of the ACB ($20,000) and the PUC ($1.00). This would be true even if the gain on the disposition were sheltered by the capital gains exemption. If X were to receive, say, a note of $100,000, X would be deemed to have received a dividend of $80,000. If X were to receive shares of Holdco with a PUC of $100,000, the PUC would be ground down to $20,000 to prevent the tax-free extraction of surplus.
If X were a non-resident (whether an individual or a corporation (Forco)), section 212.1 would operate in a similar, but not identical fashion.
If X were to receive non-share consideration with an FMV greater than the $1.00 PUC (not the $20,000 ACB), from a Holdco resident in Canada, X would be deemed to have received a dividend equal to the excess. While a capital gain on the disposition would not have been taxed in Canada unless the shares were “taxable Canadian property” (and even then only if the gain was not exempted by a tax treaty), the deemed dividend would be subject to Canadian withholding tax.
If X were to receive shares of Holdco with an FMV greater than the $1.00 PUC (not the $20,000 ACB), the PUC would be ground down to $1.00 to prevent the tax-free extraction of surplus.
Subsection 212.1(4) provides an exception to section 212.1 where a Forco disposes of shares of Opco to a Holdco that controls Forco. The Department of Finance feels that this exception has been abused. As a consequence, with respect to dispositions on or after Budget Day, the exception in subsection 212.1 will not apply where Forco owns, directly or indirectly, shares of Holdco and does not deal at arm’s-length with Holdco.
Section 247 contains rules to ensure that cross-border charges among non-arm’s length entities generally reflect prices that would be negotiated by arm’s-length parties. In this regard, certain recommendations of an international study, the Base Erosion and Profit Sharing (BEPS) project, are consistent with existing CRA practices and require no Canadian changes at this time.
The Budget proposes country-by-country reporting requirements that would allow inter-company pricing to be monitored more easily. The new rules will apply to taxation years that begin after 2015, but only to groups with consolidated revenues of at least €750 million.
The BEPS project addressed “treaty shopping,” i.e., the abuse of tax treaty networks whereby an international organization establishes a corporation in a second jurisdiction only for the purpose of taking advantage of a tax treaty between that second jurisdiction and a third jurisdiction.
The Budget indicates that future Canadian tax treaties will contain anti-avoidance provisions to counter such abuses.
Subsection 18(6) contains an anti-avoidance measure intended to curtail the avoidance of the “thin capitalization” rules by interposing an ostensibly arm’s-length lender between a Canadian borrowing entity and the real non-arm’s-length lender. A similar anti-avoidance rule is found in subsection 212(3.1) where an attempt is made to avoid Canadian withholding tax on the payment of interest to a non-arm’s-length lender by interposing an ostensibly arm’s-length lender between a Canadian borrower and the real non-arm’s-length lender.
The Budget indicates that Canada will strengthen existing rules to prevent tax avoidance in connection with back-to-back arrangements. The new rules will apply, for example, where back-to-back arrangements are intended to reduce Canadian withholding tax in connection with rents and royalties, to avoid the “upstream loan” rules (where a Canadian corporation receives a loan from a foreign affiliate to avoid receiving a taxable dividend from that affiliate) and in other more complex circumstances.
International Tax Rulings
The Budget confirms that, commencing in 2016, Canada will begin spontaneously exchanging tax rulings with other jurisdictions that agree to do the same.
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