The 2019 Federal Budget proposed amendments to broaden the scope of the Foreign Affiliate Dumping Rules (commonly referred to as “FAD” rules). These amendments may lead to withholding taxes and reductions of paid up capital (PUC) for Canadian companies that were previously not subject to these rules.
The FAD Rules Prior to the Budget
The FAD rules were intended to discourage foreign-based multinational corporations from “dumping” foreign affiliates into their Canadian subsidiaries in a manner that erodes the Canadian tax base. These rules are extremely complex.
The FAD rules generally applied when:
- A non-resident corporation ( NR Parent) controlled a corporation resident in Canada (CRIC) and combined with the NR Parent’s related entities, it owned 25 per cent or more of all the votes or fair market value (FMV) of the CRIC; and
- The CRIC made an “investment” in a foreign affiliate (FA) of the group.
An FA of a CRIC is generally a non-resident corporation in which the CRIC owns, directly or indirectly, at least one per cent of any class of shares and 10 per cent when the direct and indirect ownership of any related parties are also considered.
Generally, for purposes of the FAD rules, an “investment” by a CRIC in an FA includes situations where the CRIC:
- acquires shares of the FA;
- contributes capital to the FA;
- acquires debt of the FA from a non-arm’s length party; or
- makes a loan to the FA.
If the FAD rules apply, the PUC of an eligible class of shares of the CRIC may be reduced. Furthermore, in the event that the PUC is nominal, a dividend may be deemed to have been paid by the CRIC to the NR Parent. If there are no reductions as a result of a tax treaty, the deemed dividend would be subject to Canadian withholding taxes of 25 per cent.
A deemed dividend - and the withholding taxes - can be avoided to the extent the PUC of the CRIC or a qualifying substitute corporation is available to be reduced. In addition, if the “investment” is a loan from the CRIC to the FA and the parties file a pertinent loan or indebtedness (PLOI) election, the FAD rules will not apply. A PLOI election will require the CRIC to report interest income annually at a prescribed rate. Currently, the prescribed interest rate on a PLOI is 5.67 per cent for the 2019 third calendar quarter. There are also exceptions for certain related party reorganizations or where it can be demonstrated that the FA’s business is more closely connected with the CRIC’s business than any other entity in the corporate group. These exceptions are fairly complicated and are beyond the scope of this article.
Changes to the FAD Rules
The 2019 Federal Budget proposed to broaden the FAD rules such that a NR Parent is not limited to non-resident corporations. The FAD rules now apply where the CRIC is controlled by a non-resident individual, a non-resident trust or a combination of non-resident corporations, non-resident individuals and non-resident trusts.
Further, when a trust owns shares of a CRIC, the trust is deemed to hold a single class of 100 voting shares. Each beneficiary of the trust will be considered to own a proportional share of the 100 shares based on the proportionate FMV of their beneficial interest in the trust. Where the trust is fully discretionary, each beneficiary will be deemed to own 100 per cent of the shares.
The consequence of these changes is that the FAD rules may now apply to certain common scenarios if subsequently a CRIC makes an “investment” in a FA:
- An individual or trustee of a trust which controls the CRIC becomes a non-resident of Canada; or
- A beneficiary of a discretionary family trust becomes a non-resident of Canada.
These relatively common occurrences may now have significantly adverse tax implications for certain Canadian companies who are not familiar with these new rules. It is questionable whether the Department of Finance fully appreciated these concerns when it drafted these new rules.
The proposed FAD rule expansion applies to transactions on or after March 19, 2019, although there is currently no legislative Bill drafted that contains these new provisions, and it is unlikely that one may be introduced before the fall election.
Next Steps?
The FAD rules are complex and fact driven. Moving forward, the impact of the proposed rules means that Canadian companies, public and private, with one or more foreign affiliates, should be considering the new FAD rules anytime an “investment” is made in an FA.
For specific tax advice regarding your situation, please contact one of the tax professionals at Crowe Soberman to assist you.
This article has been prepared for the general information of our clients. Specific professional advice should be obtained prior to the implementation of any suggestion contained in this article. Please note that this publication should not be considered a substitute for personalized tax advice related to your particular situation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
