Research tax-efficient structures to facilitate real estate investing.
Navigating through the delicate nature of non-arms length transactions.
Preventing Unwanted Canada – U.S Cross-Border Tax Issues – Due Diligence Concerns – Part 3
Leading Tax Advice
Call Nicholas Kilpatrick
604-612-8620
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
- Repatriation of Funds
- Withholding taxes
- Foreign Affiliate Dumping (FAD) Rules
- Loans to and from foreign affiliates
- Thin capitalization rules
- Back-to-Back Rules
- Earnings Stripping Rules
- Reporting obligations
In part 1 of this series, numbers 1 to 3 were addressed. Parts 4 and 5 were addressed in Part 2. This final article in the series, part 3, looks at issues 6 to 8.
6. Back-to-back rules
Like the interest withholding rules, the Tax Act includes back-to-back rules that capture arrangements that may be intended to circumvent the application of the thin capitalization rules. For example, a non-resident parent that intends to heavily capitalize a Canadian subsidiary with a large amount of debt may enter into an arrangement to have a non-resident bank make a loan to the Canadian subsidiary. Since the bank is an arm’s length party, and not a “specified non-resident shareholder” of the Canadian subsidiary, absent the back-to-back rules, the thin capitalization rules would not apply to such a loan. Very generally, where there is a nexus between the loan from the bank/intermediary to the Canadian subsidiary and the arrangement between the bank/intermediary and the non-resident parent, the back-to-back loan rules could apply to deem the loan from the bank/intermediary to have been made from the non-resident parent, and deem the interest payments made by the Canadian subsidiary to be made to the non-resident parent, for the purposes of the thin capitalization rules.[1]
[1] Taylor Cao and Annika Wang, "Introduction to Inbound Investments in Canada," in 2021 YP Focus Virtual Conference (Toronto: Canadian Tax Foundation, 2021), 2: 1-59.
7. Earnings Stripping Rules
The “earnings stripping” rule in section 212 of the ITA is intended to address concerns regarding base erosion through excessive interest deductions, similar to the thin capitalization rules. rule lists the following examples of situations in which it considers base erosion by interest deductions to be inappropriate:[2]
- interest payments to related non-residents in low-tax jurisdictions;
- the use of debt to finance investments that earn non-taxable income; or
- having Canadian businesses bear a disproportionate burden of a multinational group’s third-party borrowings.
Based on the description of this rule, it will limit net interest expense (interest expense less interest income) that a corporation may deduct to no more than a fixed ratio of “tax earnings before interest, taxes, depreciation, and amortization (EBITDA).” The “tax EBITDA” is intended to be the corporation’s taxable income before accounting for interest expense, interest income, income tax, and depreciation and amortization expenses – all as determined for tax purposes. It is proposed that this fixed ratio be phased in, allowing net interest expense equal to 40% of tax EBITDA for taxation years beginning on or after January 1, 2023, and then 30% for taxation years beginning on or after January 1, 2024.
From a U.S. perspective, the earnings stripping rules may apply to limit the interest deduction available to U.S. subsidiary of a non-resident to the extent that the corporation has "excess interest expense" and its debt-to-equity ratio of the U.S. subsidiary exceeds 1.5:1. A corporation has excess interest expense to the extent that its interest expense exceeds 50% of its "adjusted taxable income." Conversely, a corporation has "excess limitation" to the extent its interest expense is less than 50% of its "adjusted taxable income." In contrast to the Canadian thin capitalization rules, excess interest expense is not deemed to be a dividend. Rather, it can be carried forward and deducted in the subsequent year to the extent there is "excess limitation" available in the year. Excess interest expense can also be deducted in the year it arises to the extent there is excess limitation carrying forward. Excess limitation carries forward for three years. Any excess interest that cannot be applied in the year it arises, or in the subsequent year, expires. It should also be noted that, to the extent the Canadian parent owns multiple U.S. subsidiaries, the earnings stripping calculation is completed on a consolidated basis. The annual excess interest expense or excess interest limitation is captured on Form 8926 - Disqualified Interest Expense Disallowed Under Section 163(j) and Related Information, which is required to be filed along the U.S. tax return.
Unlike the thin capitalization rules, the interest payments on which deductions are denied are not proposed to be treated as deemed dividends. Further, instead of losing the deduction permanently
[2] Andrew Morreale and Andrew Somerville, "Structuring Outbound Foreign Expansion for Owner Managed Businesses," in 2017 Ontario Tax Conference (Toronto: Canadian Tax Foundation, 2017) 10:1-37.
deductions that are denied by the earnings stripping rule are proposed to be able to be carried back 3 years or carried forward 20 years.
The rule is proposed to not apply in certain circumstances, for example, to a “group” if the group’s aggregate net interest expense among Canadian members is below $250,000.
8. Reporting obligations[3]
If a Canadian-resident individual or a corporation is a direct shareholder of a corporation that is a foreign affiliate or a controlled foreign affiliate, the shareholder is obligated to file a T1134 information return in respect of the affiliate. A Canadian-resident individual or corporation is also required to file a T1134 in respect of any other corporation that is a foreign affiliate or controlled foreign affiliate in which they have an indirect interest as a shareholder of another corporation, unless that indirect interest is held through a corporation resident in Canada.
A partnership may also be required to file a T1134 in a fiscal period. This will be the case if a non-resident corporation is a foreign affiliate of the partnership in the fiscal period and if persons resident in Canada who are not exempt from Part I income tax are entitled to more than 10% of the income or loss of the partnership for that fiscal period. Although the members of the partnership may also be deemed to own shares of the foreign affiliate owned by the partnership in proportion to the FMV of their interests in the partnership, there should not be duplicate reporting obligations if the members of the partnership do not own shares of the foreign affiliate except through the partnership.
T1134’s are due 10 months after the end of the year or period.
Although there is no legislative basis for the following, the CRA will administratively waive the obligation to file T1134s for “dormant” foreign affiliates of a taxpayer if the taxpayer’s total cost amount of all of their interests in foreign affiliates at any time in the year was less than CAD $100,000. The CRA classifies a foreign affiliate as dormant in a year if it had gross receipts (effectively, any cash inflow including loans and proceeds from the sale of property) of less than CAD $25,000 and at no time in the year owned property with a total FMV of more than CAD $1,000,000.
If the foreign corporation is not a foreign affiliate, then the shares or debts of that corporation are specified foreign property and must be disclosed in a T1135 information return if the Canadian shareholder’s total cost amount of specified foreign property exceeds CAD $100,000 at any time in the year. Shares and debts of a foreign affiliate are not specified foreign property, so interests in a foreign affiliate that are disclosed in a T1134 should not also be included in a T1135. Further, the cost amount of shares or debts of a foreign affiliate will be ignored in determining the total cost amount of the Canadian shareholder’s specified foreign property.
[3] 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.
Nicholas Kilpatrick is a partner with the accounting firm of Burgess Kilpatrick and specializes in tax structuring and business development for his small and medium business sized clients. Please visit our website at www.burgesskilpatrick.com.
