Tax Alert

The recent federal budget proposed changes to the Foreign Affiliate Dumping Rules (commonly referred to as “FAD” rules). The change appears to broaden their application, which could result in many unintended tax consequences that appear to contradict the Department of Finance's intent of the rules when they were first introduced.

The current FAD rules

The FAD rules are extremely complex. They apply when a non-resident corporation controls a corporation resident in Canada (CRIC), and the CRIC makes an “investment” into a foreign affiliate (FA) as part of either a transaction or a series of transactions and events. An FA of a CRIC is a non-resident corporation where the taxpayer's equity percentage is 1% or more and the equity percentage of the taxpayer and persons related to the taxpayer is 10% or more, generally meaning that the CRIC owns at least 10% in a non-resident corporation directly or indirectly with related parties.

The term “investment” is broadly defined and captures many transactions, including:

• An acquisition of shares (direct or indirect) of the FA by the CRIC
• A contribution of capital to the FA by the CRIC
• A transaction under which an amount becomes owing to the CRIC by the FA.

When the Department of Finance first introduced the FAD rules, they were meant to prevent the erosion of the Canadian tax base by having the CRIC use surplus funds or debt (resulting in an interest deduction in the Canada) to purchase non-resident corporations (whether non-arm's length or arm's length). In these situations, funds could flow back to the non-resident parent of the CRIC (as interest which may be free of withholding tax) that would otherwise be a dividend subject to Canadian withholding tax.

The above planning was used quite a bit in the multinational context.

What happens when FAD rules apply

Generally speaking when the FAD rules apply, the following can result:

• Paid-up capital (PUC) of the CRIC will be ground down to the extent of the investment in the FA.
• A dividend will be deemed to have been paid by the CRIC to the non-resident corporation, which can trigger withholding taxes of 25% (possibly reduced by a tax treaty).
• A Pertinent Loan or Indebtedness (PLOI) election can be made in some situations.

Proposed budget changes to FAD

Budget 2019 extends the application of the FAD rules by replacing the word “non-resident corporation” with “non-resident persons” in the draft legislation. Non-resident persons include:

• A non-resident individual
• A non-resident trust
• A group of persons that do not deal with each other at arm's length, comprising any combination of non-resident corporations, non-resident individuals and non-resident trusts.

In addition, the budget proposals include an extended meaning of when persons (or a group of persons) can be considered “related” with respect to the application of the FAD rules. The proposal works as follows:

• A trust is deemed to own 100 shares of the CRIC,
• A beneficiary of a trust is deemed to own their proportion of the fair market value of the interest in the trust, and
• If the trust is a discretionary trust, the beneficiary is deemed to own all shares of the CRIC owned by the trust.

Impact of the budget proposals

The impact of the proposed changes in the budget is far reaching and extends to many situations that do not fall within the spirit of the FAD rules by the Department of Finance. For example, the proposed changes could capture the following situations:

• Individual Canadian shareholder controls a Canadian corporation which in turn controls a non-resident corporation. If the individual becomes a non-resident of Canada, to the extent the Canadian entity makes an investment into the non-resident entity, the FAD rules noted above will apply. Most private Canadian shareholders have nominal PUC (rendering any option to grind PUC meaningless) and hence the application of the FAD rules could create a deemed dividend which could trigger additional taxes (withholding or corporate income tax) for the owner-manager business.
• Canadian-controlled private corporation (CCPC) which controls a non-resident corporation that undergoes an estate freeze; as a result, a Canadian trust is created (common planning among CCPCs) and the trust now controls the CCPC. If a beneficiary of the trust becomes a non-resident of Canada and the CCPC makes an investment into the foreign entity, the above FAD rules may now apply.
• Transactions resulting in a mix of Canadians and non-residents (individuals, trusts or partnerships) owning a Canadian company that owns another foreign entity. This could be the case in takeover transactions, reverse takeover transactions or private equity investments in a Canadian target that has FAs. It is a question of whether the non-residents will be dealing at arm's length.

Also, the way the rules are currently drafted would require the CRIC to do valuations every time an investment is made in the FA — this would practically be very difficult and costly for many private corporations.

Tax professionals and their clients using the above three structures were generally not focused on eroding the Canadian tax base, especially in scenarios involving private Canadian corporations. The impact of the proposed rules on these situations represents surprising consequences for the tax community. They are clearly something the Department of Finance will need to consider as it moves forward on these measures.

We will continue to monitor these proposals. However, business owners impacted by the above situations may need to plan on restructuring their business affairs if the rules are enacted as proposed.

If you have questions about how the above rules may impact you, please contact a member of our International Tax Team or your local BDO advisor.