Canada Makes Major Changes to International Tax Rules
March 2007
Release No: 07-02
On Monday, March 19, 2007, as part of its annual budget, the Canadian government announced fundamental changes that impact Canadian companies with operations in foreign jurisdictions. The proposals will require these companies to review how their foreign operations are structured and, in particular, to review any Canadian borrowings which are used to finance their foreign investments.
Interest Deductibility for Foreign Active Business Income
In what is the most significant change in Canadian tax policy in years as it relates to investments made in foreign corporations, the budget proposes to disallow the deduction of interest on money borrowed to make investments in these foreign affiliates except to the extent that income becomes taxable in Canada. Under existing rules, Canadian corporations can deduct interest expense on money borrowed to finance foreign affiliates, even if the income generated in those affiliates may never be subject to Canadian tax. Dividends received by Canadian companies from foreign affiliates which are resident in countries that have a tax treaty with Canada such as the US, are not subject to Canadian tax if they are paid out of foreign-source active business income (which is referred to as a payment out of “exempt surplus”). Therefore, in many situations, the interest paid on foreign affiliate borrowings becomes a deduction against Canadian-source business income.
The restriction on interest deductibility will apply to interest payable after 2007 on new debt, which is debt incurred on or after March 19, 2007 (otherwise than pursuant to an agreement in writing entered into before that date). Existing non-arm’s length debt will be subject to the new rules for interest payable after 2008 or after the expiry of the current term of the debt, whichever is sooner. With respect to arm’s length debt, the new rules will apply for interest payable after 2009 (or after the expiry of its current term, whichever is sooner). Interest denied under the new rules will be pooled for deduction, net of exempt dividends received, if and when the foreign affiliate’s shares generate taxable income for the Canadian company. The proposals also catch indirect financings (i.e. where the borrower and the investor are different parties).
The proposals will impact all Canadian corporations who have Canadian borrowings targeted at foreign investment, where the interest deduction exceeds the foreign-source income taxable in Canada. Most financings in these corporate groups have been arranged to take advantage of the current rules which allow interest to be deductible in Canada. With this largely unanticipated proposed change to the Canadian rules, Canadian companies will have to revisit how their international operations are financed. The proposals clearly increase the cost of making investments in foreign affiliates for Canadian companies.
Definition of Active Business Income Under the Foreign Affiliate Rules
Under current rules, certain passive income of a foreign affiliate of a Canadian company will be re-characterized as active business income. The types of income that will qualify are interest, royalties and leasing income, where the income was deductible in computing the active business income of another foreign affiliate. These rules are beneficial in two respects. First, rules which tax passive income earned in a controlled foreign affiliate in the hands of the Canadian owner will not apply. And, as active business income, this income can be repatriated to Canada as a tax-free dividend in certain circumstances.
The budget proposes to limit the application of current rules to Canadian companies that have a direct or indirect economic interest of at least 10% in the company paying the interest, royalties or lease amounts, in order to have these payments treated as active business income for Canadian tax purposes in the recipient foreign affiliate’s hands. Under current rules, the paying entity need only be related to the Canadian company.
This change will affect Canadian companies who enter into financing or other arrangements with companies in their corporate group in other jurisdictions where the Canadian company does not have an economic interest in these companies.
Improving Tax Information Exchange
In an effort to improve the exchange of information with the tax authorities where Canadian businesses are operating, the budget announced that no new tax treaties and revisions to existing treaties (including treaties currently under negotiation) would be approved that do not include the new OECD standards with respect to exchange of tax information. And to further encourage countries to enter into Tax Information Exchange Agreements with Canada, the existing exempt surplus rules for dividends received out of active business income earned by foreign affiliates resident in treaty countries will be extended to include active business income earned by a foreign affiliate residing in a country that has agreed to a tax information exchange agreement with Canada. In addition, income earned by foreign affiliates in countries which have neither signed a tax treaty or a tax information exchange agreement with Canada, will be taxed currently in the hands of the Canadian shareholders of those affiliates (in the same manner as passive income currently is).
The Canada-US Tax Treaty
There was some good news in the budget. The government announced that the long awaited update to the Canada-US Tax Treaty was near completion and in the budget, the government confirmed the following:
- The withholding tax on interest under the treaty, currently 10%, will be eliminated once the changes are fully phased-in. Withholding tax on interest paid to arm’s length parties will be eliminated for the first calendar year following the entry into force of the treaty changes. For non-arm’s length interest payments, the withholding tax rate will be reduced over three years starting with a reduction to 7% for the first calendar year following the entry into force of the treaty changes, with reductions to 4% and then to 0% in each of the following two years.
- Treaty benefits will be extended to US Limited Liability Companies under the new treaty.
Other Changes
The budget also contained the following measures impacting Canadian companies that do business internationally:
- Withholding Tax on Interest – Once the withholding tax elimination on both arm’s length and non-arm’s length interest is implemented in the Canada-US Tax Treaty, the government will eliminate withholding tax on interest paid to arm’s length non-residents, regardless of their country of residence. This is a welcome development that will lower borrowing costs for non-residents who finance Canadian businesses and will mean that these borrowings will no longer have to be for a term of more than five years to avoid withholding tax under current rules.
- Additional Resources for the Canada Revenue Agency (CRA) – The budget provides for additional funding for auditing and enforcement. This will allow the CRA to increase its audit activities in the transfer pricing and international tax avoidance areas.
- Review of Existing Technical Proposals – There are a number of technical rules that have yet to be passed into law (which were released as draft legislation on February 27, 2004). These proposals will be reviewed and re-evaluated in the light of the budget measures to ensure those proposals are consistent.
The international tax measures contained in the budget will impact every Canadian company doing business abroad through foreign corporations. It’s critical for these companies to review their current operations to determine how the budget will affect them.
For more information on how these rules will affect you, contact your BDO advisor.
Please note: this material is general in nature and should not be relied upon
to replace the requirement for specific professional advice. © March 2007, BDO Dunwoody LLP
