Canada’s new international business tax proposals: a closer look

by Kabir Jamal, Goodmans LLP

We previously reported that Canada’s Department of Finance had released draft tax legislation to implement measures announced in the 2016 Federal Budget.  These measures include (among other things) new rules to address debt parking transactions undertaken to avoid foreign exchange gains on foreign currency denominated debt, the extension of the back-to-back loan rules, and the implementation of the OECD’s country-by-country reporting requirements. These measures are discussed in greater detail below.

Debt parking to avoid foreign exchange gains

Under Canada’s existing tax laws, a debtor may avoid realizing a foreign exchange gain on a foreign currency denominated debt issued to an arm’s length creditor by “parking” the debt with a non-arm’s length party (such as an affiliate).  A debt obligation generally will be considered to be a “parked obligation” where (i) a non-arm’s length party acquires the debt obligation, (ii) the creditor becomes non-arm’s length with the debtor or (iii) if the debtor is a corporation, the creditor acquires a significant interest in the debtor.

The proposed rules address this type of avoidance transaction by deeming the debtor to have realized, upon the relevant debt becoming a “parking obligation,” any accrued foreign exchange gain that would have otherwise been realized if the debt had been repaid.  The amount of the foreign exchange gain that is realized is computed with reference to the fair market value of the debt at the time it becomes a “parked obligation” or, if the debt becomes a “parked obligation” as a result of being acquired by a non-arm’s length party, the amount paid by such party to acquire the debt.

In order for the deemed realization rule to apply, it must reasonably be considered that one of the main purposes of the transactions or series of transactions that resulted in the debt becoming a “parked obligation” was to avoid the realization of the foreign exchange gain.

Similar rules have been proposed to deal with accrued foreign exchange gains on pre-transition and pre-reversion debts under Canada’s functional currency tax reporting regime.

As currently drafted, the proposed rules do not prevent a debtor from realizing the same foreign exchange gain twice: once, when the relevant debt becomes a “parked obligation”; and again, when the relevant debt is repaid or otherwise settled. It is expected that this oversight will be corrected in the revised draft legislation.

The proposed rules will apply to debts that become parked obligations on or after March 22, subject to transitional relief.

Extension of the back-to-back rules

Canada’s federal income tax laws contain rules designed to prevent certain direct or indirect shareholders of a corporation (or connected persons or partnerships) from receiving property as a tax-free loan, rather than as a taxable dividend or other taxable amount.

Where applicable, these shareholder loan rules require the amount of the loan received by the debtor to be included in computing the debtor’s income for Canadian tax purposes. Where the debtor is not resident in Canada, the included amount is deemed to be a dividend which gives rise to non-resident withholding tax.

The draft legislation proposes to extend the shareholder loan rules to include so-called “back-to-back loan” arrangements.  These arrangements typically involve the relevant creditor corporation making loans to its direct or indirect shareholders (or connected persons or partnerships) indirectly, through one or more intermediaries, rather than directly.  The proposed rules will apply to back-to-back loan arrangements made on or after March 22 or in place on March 22.

In the 2014 Federal Budget, back-to-back loan rules were introduced to Canada’s non-resident withholding tax regime to combat schemes involving the interposition of an intermediary between a Canadian debtor and non-resident creditor to avoid non-resident withholding tax on interest payments. The draft legislation proposes to add “character substitution” provisions to prevent taxpayers from avoiding the existing rules by substituting economically similar arrangements (e.g., shares or a lease, license or similar arrangement) between the intermediary and the non-resident creditor.

The draft legislation also proposes to expand the scope of the existing rules to target back-to-back  arrangements in respect of rents, royalties and similar payments, where the rate of non-resident withholding tax on payments to the intermediary is less than the rate that would have applied if the payments had been made to the non-resident directly. The proposed expansion of the existing back-to-back rules will apply to payments made after 2016.

Country-by- country reporting

The draft legislation sets out new country-by-country reporting requirements consistent with the minimum standards developed by the OECD to address high-level transfer pricing and other base erosion and profit-shifting related risks.

The new reporting requirements generally will be applicable in respect of multinational enterprise groups with total consolidated group revenue of €750 million or more. Where the requirements apply, a country-by-country report must be completed in prescribed form and filed in prescribed manner with Canada’s tax authorities.

Failure to file the report knowingly, or under circumstances amounting to gross negligence, will attract penalties of $500 per month for up to 24 months. The new reporting requirements will apply to reporting fiscal years of multinational enterprise groups that begin on or after January 1.

— Kabir Jamal is an attorney with Goodmans LLP, Toronto, where he specializes in domestic and international corporate taxation, including cross-border mergers, corporate reorganizations, domestic and international corporate finance, debt restructurings, and private equity investments. He can be reached at [email protected].

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