Preventing Unwanted Canada – U.S Cross-Border Tax Issues – Due Diligence Concerns – Part 1

It is common for businesses to consider international expansion as a means to achieve growth. Given the geographic proximity of Canada and the U.S., it is logical that many Canadian businesses would consider expanding into the U.S. and vice-versa.

Below are discussed a few tax and compliance issues that must be considered when Canadian corporations expand into the U.S

1. Repatriation of Funds
2. Withholding taxes
3. Foreign Affiliate Dumping (FAD) Rules
4. Loans to and from foreign affiliates
5. Thin capitalization rules
6. Back-to-Back Rules
7. Earnings Stripping Rules
8. Reporting obligations

This article will discuss Numbers 1 to 3 above.  The remaining issues will be discussed in subsequent articles.

1. Repatriation of Funds

Pursuant to subsection 90(1) of the Income Tax Act (ITA) , a Canadian-resident taxpayer is required to include in its income for a particular taxation year all dividends received from non-resident corporations. A Canadian-resident corporate taxpayer receiving a dividend on a share of an FA owned by the taxpayer may be entitled to a full or partial deduction in computing its taxable income under section 113. The amount of the deduction available under section 113 depends in part on the surplus account of the FA in respect of the taxpayer from which the dividend is prescribed to have been paid. There are four surplus accounts, and regulation 5901 provides that dividends are prescribed to be paid out of the surplus accounts in the following order:[1]

1) exempt surplus, which includes income and profits earned by an FA that is resident in a "designated treaty country" from an "active business" (as defined in subsection 95(1)) carried on by it in Canada or a designated treaty country;

[1] Tim Barrett and Kevin Duxbury, "Corporate Integration: Outbound Structuring in the United States After Tax Reform," in Report of Proceedings of the Seventieth Tax Conference, 2018 Conference Report (Toronto: Canadian Tax Foundation, 2019), 18:1-76.

2) taxable surplus, which includes income and profits earned by an FA that is FAPI, or an FA's net earnings from carrying on an active business that is not included in exempt surplus;

3) hybrid surplus, which includes the taxable and exempt portion of capital gains realized by an FA from the disposition of a partnership interest or shares of another FA; and

4) pre-acquisition surplus, which is anything that is not deemed to be paid from one of the foregoing surplus accounts and effectively represents the taxpayer's investment in the FA.

Paragraphs 113(1)(a) and (d) provide a full deduction for dividends prescribed to have been paid out of exempt surplus and pre-acquisition surplus, respectively. Paragraphs 113(1)(a.1), (b), and (c) provide a deduction in respect of applicable underlying foreign tax (UFT) paid by an FA  and any non-business-income tax paid by the recipient corporation in respect of dividends (for example, withholding tax) prescribed to have been paid out of hybrid surplus and taxable surplus. For dividends prescribed to have been paid from taxable surplus, the deduction under paragraph 113(1)(b) is limited to the UFT multiplied by the corporation's relevant tax factor (RTF) for the year, minus one.

Taxpayers that receive taxable surplus dividends on a share of a corporation that was a CFA are also entitled to a subsection 91(5) deduction in computing their income for the year. This deduction equals the net amount added to the taxpayer's ACB of the share under subsection 92(1)   effectively, this is the portion of FAPI on the share of the CFA previously included in the taxpayer's income that was not deducted under subsection 91(4). Subsection 91(5) therefore aims to ensure that income or profits of an FA are taxed only once in Canada. For corporations, the subsection 91(5) deduction is available only to the extent that the amount of a dividend exceeds the portion deductible under paragraph 113(1)(b). For individuals, regulation 5900(3) deems all dividends to be paid out of taxable surplus for the purposes of subsection 91(5).

Amounts deductible by a CCPC under section 113 are added to its GRIP. A positive GRIP balance allows a CCPC to pay or declare eligible dividends on its shares. Note that no portion of dividends paid by a non-resident corporation (including a CFA) is added to a shareholder's capital dividend account. This can lead to unfavourable tax results where an FA of a "private corporation" (as defined in subsection 89(1)) realizes a capital gain on a disposition of property, rather than the private corporation realizing a capital gain directly.

2.  Withholding taxes

The Canadian domestic withholding tax rate on payments of passive-type income by a Canadian taxpayer to a non-resident person is 25% regardless of the characterization of the domestic payer or the non-resident recipient.   However, a reduced withholding tax rate may be available under a Canadian tax treaty depending on the characterization of the non-resident payee and, in some circumstances, the Canadian payer.

Under the Canada-US Treaty, reduced treaty withholding tax rates are available only if the US payee is entitled to treaty benefits in respect of the payment received. Whether or not the US payee is entitled to treaty benefits requires a determination of (a) whether the US payee is resident in the US for purposes of the treaty; (b) whether the US payee is the “beneficial owner” of the payment; (c) whether the limitation on benefits provisions  apply to deny treaty benefits; and (d) the application of the rules in Articles IV(6) and IV(7) of the treaty dealing with fiscally transparent entities. The following expands on each of these four considerations for eligibility for reduced treaty withholding rates.

Generally the US payee will be resident in the US for purposes of the Canada-US Treaty if it is a person (including a corporation) that, under the laws of the US, is liable to tax therein by reason of the person’s domicile, residence, citizenship, place of management, place of incorporation or any other criterion of similar nature.  Pursuant to the treaty residence tie-breaker rules, a corporation that is a resident of both Canada and the US under domestic laws (for example, a corporation that is domiciled in the US but has its central management and control in Canada) is deemed to be a resident of the country under the laws of which it was created.

Articles IV(6) and IV(7) of the Canada-US Treaty contain rules to either grant or deny treaty benefits where amounts are paid by or to a fiscally transparent entity.   Article IV(6) is a relieving provision designed to allow access to treaty benefits where a resident of a contracting state derives income through an entity that is fiscally transparent under that country’s laws and the country taxes the income as if the resident had derived the income directly. In the inbound context, this provision is relevant where a Canadian taxpayer (i.e., the Canadian corporate investee) pays an amount to a US partnership, a US LLC or another type of entity (or through a chain of entities) that is considered a fiscally transparent entity from a US tax perspective.

Article IV(7) can apply to deny treaty benefits where one or both parties to the relevant payment is a fiscally transparent entity, regardless of how Article IV(6) may apply to the payment. Article IV(7) is intended to prevent the use of hybrid entities and the selective use of debt and equity to either duplicate interest deductions in Canada and the US or generate an interest deduction in one country that is not income in the other country.

3.  Foreign Affiliate Dumping Rules

Section 212.3, known as the Foreign Affiliate Dumping (FAD) rules is a broad provision described by the Department of Finance as "effectively extend[ing] an existing cross-border surplus stripping rule [section 212.1] to cover transactions involving foreign affiliates."  Referred to as the foreign affiliate dumping (FAD) rules, section 212.3 was designed to restrict a non-resident corporation ("parent") from using a corporation resident in Canada (CRIC) as an intermediary to invest in a foreign affiliate. The rules are intended to prevent the perceived erosion of the part I tax base (resulting from the exempt treatment of dividends from foreign affiliates in combination with the deductibility of debt incurred by the CRIC to invest in the foreign affiliate), as well as the part XIII tax base (resulting from the extraction of corporate surplus not subject to withholding tax). A CRIC caught by the FAD rules is deemed to have paid a dividend to the parent subject to part XIII withholding tax or to have reduced the paid-up capital (PUC) of one or more relevant classes of its shares.

The 2019 budget proposed significant changes to the FAD rules. The discussion of these new rules concerns the legislative proposals released July 30, 2019.  However, these proposals are subject to a comment period that expired on October 7, 2019. At the time of writing, it is unclear whether Finance will introduce further changes to the proposals based on feedback. If enacted, the new FAD measures will apply to transactions or events occurring after March 18, 2019.

The Parent Trap

Whereas the FAD rules are currently limited to a CRIC controlled by a non-resident corporation, the proposals will extend the rules to a CRIC that is controlled by (1) a non-resident individual or (2) a group of non-resident persons not dealing with each other at arm's length. Thus, a "parent" under the FAD rules can refer to a corporation, a natural person, or a trust.

A variety of previously innocuous circumstances may now be subject to these rules. A Canadian corporation that is owned by a non-resident individual is a CRIC for the purposes of the FAD rules. As a result, the FAD rules could apply to situations where an owner-manager who controls a CRIC with a foreign affiliate emigrates abroad and ceases to be a resident of Canada, or who dies and whose shares are acquired by an estate that is not a resident of Canada.

The conditions under which the FAD rules, as proposed, could apply are not always so easily identified. For example, determining whether a group of non-resident persons deals with each other at arm's length would, absent a deemed non-arm's-length relationship,  be a factual determination to which a degree of uncertainty attaches.

The key takeaway is that because a reference to a "parent" will no longer be limited to a corporation, the proposed amendments to the FAD rules, if passed, will apply to a much wider range of situations than was previously the case.

"More Closely Connected Business" Exception

Subsection 212.3(16)  of the current FAD rules sets out the "more closely connected business" (MCCB) exception. This provision generally operates to stop the FAD rules from applying when an investment by a CRIC in its foreign affiliate can be shown to "belong" more to the CRIC than to the parent, based on certain enumerated factors.   While there are no substantive amendments proposed for the MCCB exception, a discussion of the exception is relevant because it may no longer be possible to satisfy the exception in circumstances to which the FAD rules, as proposed, would apply.

For example, one of the enumerated factors in the MCCB exception requires that (1) the officers of the CRIC had and exercised principal decision-making authority in respect of the investment in the foreign affiliate, and (2) a majority of those officers were resident and working principally in Canada at the time of the investment.  In the example of the emigrating owner-manager, it is unlikely that this factor could be satisfied if the owner-manager is the sole decision maker of the CRIC's business.

Generally, the FAD rules allow a CRIC to suppress the PUC of its shares, rather than pay withholding tax on the deemed dividend that otherwise arises on the investment in the foreign affiliate.  This PUC offset mechanism is the usual means by which a taxpayer avoids withholding tax on the deemed dividend. However, this self-help remedy would seldom be a viable option for a private company, whose voting shares usually have low PUC. Accordingly, lack of access to the MCCB exception is particularly problematic for owner-managers.