Canadian and U.S. Tax Law: a review of 2013 and a look forward to 2014
21 January 2014
Posted by: Authors: R. Ian Crosbie and others
Authors: R. Ian Crosbie, K.A. Siobhan Monaghan, Raj Juneja, Nathan Boidman, Brian Bloom, Michael N. Kandev, Peter A. Glicklich and Abraham Leitner
The year 2013 was very eventful from a tax perspective, with significant developments on the legislative front. This article looks back at tax developments in Canada and the United States in 2013 and offers a look forward to possible Canadian and U.S. tax developments in 2014.
I. CANADIAN TAX REVIEW AND OUTLOOK
From 2008 to 2012, corporate taxpayers in Canada operated in an environment of declining tax rates, with the general federal corporate income tax rate falling to 15% in 2012. In connection with these federal tax rate reductions, the Canadian Minister of Finance had encouraged all Canadian provinces to decrease their provincial corporate tax rates to 10% by 2013 so that Canada could have a national corporate tax rate of 25%.
Only two provinces (British Columbia and New Brunswick) had responded by dropping their corporate tax rates to 10%. However, British Columbia increased its corporate tax rate to 11% on April 1, 2013 and New Brunswick increased its corporate tax rate to 12% on July 1, 2013. This leaves Alberta as the only province with a combined federal and provincial rate of 25% - Alberta's provincial corporate tax rate has been at 10% since 2006.
While Ontario had originally intended to gradually decrease its provincial tax rate to 10% by July 1, 2013, in its 2012 budget Ontario announced that its corporate tax rate would be frozen at 11.5%, with any further rate decreases deferred until Ontario's deficit had been eliminated. Thus, the combined federal and provincial corporate tax rate in Ontario remains at 26.5%.
Although the goal of a 25% Canadian national corporate tax rate by 2013 was not achieved, the corporate tax rates across Canada generally compare very favourably with those of the United States and the other members of the G7 (other than the United Kingdom).
Key Canadian Tax Developments in 2013
2013 was a remarkable year for federal income tax legislation. An embarrassing back-log of legislative initiatives, budget proposals and technical "tweaks" that had accumulated over more than a decade was finally enacted. In addition, an unusually large number of new income tax measures were proposed (and, in some cases, enacted) in 2013 outside of the usual budget process. Separately, Canadian courts at all levels delivered important tax decisions.
The following provides a brief overview of some of the more significant developments.
Budget and Bill C-4
The 2013 Canadian federal budget, delivered March 21, 2013, continued the recent trend of tightening tax rules and eliminating perceived loopholes. A number of the income tax initiatives announced in the budget were included in Bill C-4, which received Royal Assent on December 12, 2013. The significant tax measures include:
- Thin Capitalization Amendments.The Canadian thin capitalization rules were amended by extending their application to Canadian trusts, certain non-resident trusts and non-resident corporations that carry on business or own rental properties in Canada. The thin capitalization rules were also significantly tightened in 2012 (see"Taxation Measures in the 2012 Federal Budget"). When these changes are taken together, the scope and restrictiveness of the Canadian thin capitalization rules have been significantly expanded, while their basic framework has been retained.
- Loss Trading Amendments.Rules in the Income Tax Act (Canada) (the "ITA") restricting tax loss trading have focused on corporate tax losses and keyed off the acquisition of legal control of the corporation (in most cases). These rules have been expanded through the introduction of loss restriction rules triggered by the acquisition of equity ownership (rather than voting control) of a corporation, and their extension to trusts that have experienced a "loss restriction event".
- Character Conversion Rules. These new rules target transactions that are used to convert what would otherwise be ordinary income into capital gains. A significant number of mutual funds used investment strategies that were affected by these rules. The rules have much broader application than their understood purpose and apply to many transactions that have no tax motivation. For example, these rules can apply to many typical put/call transactions.
- Synthetic Disposition Arrangement Rules.These new rules are intended to target so-called "monetization" transactions that limit a taxpayer's economic gain or loss from a security which the taxpayer continues to own. They apply both to deem dispositions where the securities involved have appreciated in value and to prevent the use of such transactions to avoid dividend and foreign tax credit stop-loss rules in the ITA. As with the character conversion rules, these rules have much broader application than their understood purpose and can apply to many transactions that have no tax motivation. In addition, both the character conversion and the synthetic disposition arrangement rules may apply to the same transaction.
- Non-Resident Trust Amendments.To address aspects of the Federal Court of Appeal's decision in The Queen v. Sommerer, the 2013 budget included amendments relating to non-resident trusts. For a summary of the Sommerercase, see "U.S. and Canadian Tax Law: A Review of 2012 and a Look Forward to 2013".
In the 2013 budget, the Minister of Finance also stated that the government had completed its previously announced initiative to consider adopting a formal loss transfer system or consolidated tax reporting regime for corporate groups in Canada. The Canadian government has determined that moving to a formal system of corporate group taxation is not a priority, and it appears that the government has (once again) abandoned the concept.
For a more detailed discussion of the measures mentioned above and the other 2013 budget measures, see "2013 Federal Budget Highlights".
Enactment of butterfly and tax bump amendments
Bill C-4 also enacted amendments to the butterfly rules (which facilitate divisive reorganizations) and the tax bump rules announced on December 21, 2012.
These amendments generally implemented technical corrections to the butterfly and bump rules which the Department of Finance had promised to make in comfort letters issued to taxpayers that date as far back as 2002. In addition to addressing the comfort letters, the changes included other amendments intended to allow the tax bump in a wider range of circumstances.
Enactment of comprehensive technical amendments
On June 26, 2013, the most voluminous piece of Canadian income tax legislation in over a decade (Bill C-48) became law. Bill C-48 implemented a wide range of proposed technical amendments that had been outstanding for a number of years. The legislation included, among other things:
- amendments affecting reorganizations of and distributions from foreign affiliates;
- rules targeting "upstream loans" by foreign affiliates;
- rules taxing non-resident trusts and their beneficiaries;
- amendments to the offshore investment fund rules;
- rules targeting "foreign tax credit generator" transactions;
- rules limiting the deduction of contingent interest and other expenses;
- amendments to the real estate investment trust rules;
- rules affecting tax bumps in respect of shares of foreign affiliates;
- amendments to the securities lending arrangement rules;
- rules implementing a new reporting regime for tax avoidance transactions; and
- rules addressing non-competition agreements and other restrictive covenants.
The Canadian government's attempts to challenge perceived treaty shopping in court have been markedly unsuccessful. In the 2013 budget, the government restated its concern that treaty shopping poses significant risks to the Canadian tax base and announced an intention to consult on possible measures to challenge treaty shopping while preserving a business tax environment that is conducive to foreign investment. On August 12, 2013, the Department of Finance released a consultation paper on treaty shopping.
The consultation paper outlined a number of possible measures for combating treaty shopping. The paper defined treaty shopping as a situation in which a person who is not entitled to the benefits of a tax treaty uses an intermediary entity that is entitled to such benefits in order to indirectly obtain those benefits.
It appears that the Canadian government has determined that rules to address treaty shopping are necessary but is still considering which measures should be adopted in Canada. Given that Canada has substantially relaxed its taxation of capital gains realized by non-residents and interest paid to non-residents, one might have thought that treaty shopping is now a less significant concern than it may have been in the past. In published responses to the consultation paper, including by the Joint Committee on Taxation of the Canadian Bar Association and the Chartered Professional Accountants of Canada, there is substantial opposition to the perceived direction the government is taking on this issue. It remains to be seen whether the Department of Finance will propose measures that will have a significant impact on investments in Canadian companies by non-residents.
The Canadian government's treaty shopping initiative is running in parallel to the review by the Organisation for Economic Co-operation and Development (the "OECD") of base erosion and profit shifting. One of the OECD's action items is to develop model treaty provisions and recommendations for domestic rules to prevent the granting of treaty benefits in inappropriate situations by September 2014.
Amendments to the foreign affiliate dumping rules
On August 16, 2013, the Canadian government released proposals to amend various aspects of the "foreign affiliate dumping rules", which themselves were introduced in 2012. These amendments are generally intended to be relieving in nature.
While the proposed amendments are for the most part welcome, the rules are still much broader than their stated objectives would suggest necessary, contain numerous traps and will continue to deter many legitimate foreign investments in Canadian companies.
The foreign affiliate dumping rules can have significant consequences for foreign controlled Canadian corporations with foreign subsidiaries and for acquisitions of Canadian corporations with significant foreign subsidiaries, even in apparently benign situations. Taxpayers to whom these rules may be relevant are strongly encouraged to contact a member of the Davies tax group.
Foreign affiliate amendments
On July 12, 2013, the Minister of Finance released for consultation draft amendments to the foreign affiliate rules (including a number of amendments previously addressed in comfort letters) and certain other international tax measures (including a broadening of the definition of "taxable Canadian property" in circumstances where public company shares and mutual fund trust units are held by a partnership).
The July 12, 2013 legislation addresses highly technical, but often important, issues including: (i) rules providing for the inclusion of stub period foreign accrual property income ("FAPI") of a controlled foreign affiliate ("CFA") where the taxpayer's interest in the CFA changes during the year; (ii) rules clarifying certain aspects of the treatment of foreign corporations without share capital (such as U.S. limited liability companies) and Australian trusts; (iii) amendments addressing the application of the foreign affiliate rules to structures containing partnerships; (iv) an amendment broadening an intra-group financing safe harbour (clause 95(2)(a)(ii)(D) of the ITA); (v) a relieving amendment to an anti-base erosion rule relating to the provision of services (paragraph 95(2)(b) of the ITA); and (vi) amendments denying a tax-deferred merger of foreign affiliates where the merger is part of a transaction or series of transactions that includes the sale of shares of the merged corporation to an arm's length person.
Tax information exchange agreements (TIEAs)
Canada continued to expand its TIEA network in 2013 as it signed six more TIEAs (Bahrain, the British Virgin Islands, Brunei, Panama, Uruguay and Liechtenstein). Canada now has a total of 17 TIEAs in force. Five additional TIEAs have been signed but are awaiting Royal Assent, and Canada is in TIEA negotiations with eight countries. The Department of Finance has been actively seeking TIEAs with tax haven countries in order to improve domestic tax enforcement.
To encourage tax havens to enter into TIEAs with Canada, dividends received by a Canadian corporation out of active business income of a foreign affiliate resident in a jurisdiction with which Canada has a TIEA have been made exempt from Canadian tax. As a stick to go along with this carrot, active business income of a controlled foreign affiliate is taxed in Canada on an accrual basis (in the same manner as foreign passive income) where the controlled foreign affiliate is resident in a jurisdiction that does not enter into a TIEA with Canada within 60 months of Canada seeking to enter into negotiations for a TIEA with that country.
With 17 TIEAs now in force (including with the Cayman Islands and Bermuda), the range of attractive jurisdictions within which to establish foreign affiliates of Canadian corporations has grown significantly, and traditional notions about inappropriate offshore structuring can be challenged.
Supreme Court recognizes rectification in Québec
The taxpayers in the Québec v. AES and Québec v. Riopel cases undertook transactions that were intended to occur on a tax-deferred basis. However, in both cases, the intended tax-deferral was not achieved because of errors made by tax advisors in the implementation of the transactions. As a result of these errors, Revenue Québec and the Canada Revenue Agency issued notices of assessment claiming outstanding tax balances.
Following the Ontario Court of Appeal's decision in Attorney General of Canada v. Juliar in 2000, courts across the common law provinces have permitted rectification of transactions where the transactions did not achieve specific tax objectives that the taxpayers intended to obtain in undertaking the transactions. However, there has been uncertainty as to whether rectification beyond correcting mere clerical errors would be permitted under Québec's civil law.
The Supreme Court held that the Civil Code of Québec did not preclude the rectification of transactions. The Supreme Court stated that the common intention of the parties was expressed erroneously in all the writings prepared to carry out the tax plans on which they had agreed and it was appropriate to remedy those errors to reflect the common intention of the parties. The Supreme Court held that the tax authorities do not have the right to benefit from contractual documents that do not reflect the common intention of the parties due to an error in the preparation of documents if the parties agree to correct the error and the court has determined that the impugned documents were truly inconsistent with the parties' common intention.
The Attorney General of Canada intervened in these two cases and argued that the Supreme Court should consider and reject the common law jurisprudence developed after Juliar. In particular, the Attorney General argued that the common law courts have unduly extended the concept of rectification in tax cases since the Juliar decision. The Supreme Court did not address these arguments directly as only the Québec civil law was relevant to the cases at hand, but the decision may be seen as a favourable indicator in common law jurisdictions as well.
Solicitor-client privilege waived by including client's accountants in communications
In Imperial Tobacco v. The Queen, the Tax Court considered whether certain communications were protected by solicitor-client privilege. In Canada, legal advice from a lawyer to his or her client is protected by solicitor-client privilege unless the privilege is waived. Advice from an accountant is not protected by privilege in Canada.
In this case, the Tax Court considered, among other things, whether privilege in respect of advice provided by the client's lawyers through e-mails was lost by the lawyers also addressing the e-mails to the client's external accountants. The Tax Court stated that there was little evidence that the role of the external accountants was integral to the solicitor-client relationship. Accordingly, the Tax Court concluded that including the accountants in the e-mails constituted disclosure to a third party and resulted in a waiver of solicitor-client privilege.
Tax Court upholds transfer pricing adjustment
The Tax Court of Canada released its long-awaited transfer pricing decision in McKesson Canada v. The Queen. In this case, the taxpayer sold its receivables to its intermediate Luxembourg parent at a 2.206% discount to their face amount. The Canada Revenue Agency (the "CRA") reassessed the taxpayer's 2003 taxation year on the basis that the discount rate would have been 1.013% if the transactions had been entered into between arm's length parties. The CRA did not assess additional transfer pricing penalties since the taxpayer produced contemporaneous documentation, although in a footnote to the decision the Tax Court rather unusually appears to question whether the documentation produced by the taxpayer satisfied the contemporaneous documentation requirements in the ITA. The Tax Court considered the expert evidence produced at trial by the taxpayer and discounted much of the evidence as being advocacy work.
In considering the appropriate transfer pricing analysis, the Tax Court suggested that OECD commentaries were not relevant by stating "OECD commentaries and Guidelines are written not only by persons who are not legislators, but in fact are the tax collection authorities of the world".
The Tax Court concluded that its best estimate of an arm's length rate was between .959% and 1.17%. In addition, the Tax Court stated that the taxpayer was not able to establish sufficient credible and reliable evidence that the 2.206% discount was computed based upon arm's length terms and conditions. The Tax Court went on to uphold the CRA's transfer pricing adjustment using the discount rate of 1.013%, which was within the arm's length range determined by the Tax Court.
The CRA also made a secondary adjustment by assessing the intermediate Luxembourg parent and the taxpayer for withholding tax (in the case of the taxpayer, for a failure to withhold) on a deemed dividend. The assessment for the deemed dividend was under the shareholder benefit provisions in the ITA on the assertion that the taxpayer conferred a benefit on its Luxembourg parent by selling the receivables at below their arm's length price. (The ITA was amended effective March 29, 2012, to add a specific provision in the transfer pricing rules that treats all secondary adjustments as dividends subject to withholding tax.) The taxpayer only challenged the secondary adjustment on the basis that the assessment for withholding tax was statute barred under the Canada-Luxembourg tax treaty but the Tax Court held it was not.
The taxpayer in McKesson has appealed the Tax Court's decision to the Federal Court of Appeal.
GAAR applies to transactions that avoid debt forgiveness
In Lecavalier v. The Queen, Ford U.S. was selling a Canadian subsidiary (Greenleaf) to a Canadian purchaser for a purchase price of $10 million, which was less than the $25 million of debt that was owing by Greenleaf to Ford U.S. To avoid the application of the debt forgiveness rules, prior to the sale of Greenleaf to the purchaser, Ford U.S. contributed $15 million in cash to Greenleaf as the subscription price for Greenleaf shares. The cash was subsequently used by Greenleaf to repay $15 million of the debt that was owed by Greenleaf to Ford U.S. The balance of the debt was then sold to the purchaser at a price close to its face amount and the Greenleaf shares were sold for a nominal amount.
If the $15 million of debt had been exchanged for Greenleaf shares, Greenleaf would have realized debt forgiveness of $15 million by virtue of paragraph 80(2)(g) of the ITA. On this basis, the Tax Court concluded that paragraph 80(2)(g) was circumvented (and, thus, abused) and GAAR applied to result in debt forgiveness to Greenleaf.
Tax Court considers the paragraph 95(6)(b) anti-avoidance rule
In Lehigh v. The Queen, the Tax Court considered the application of the anti-avoidance rule in paragraph 95(6)(b) of the ITA. Paragraph 95(6)(b) provides that where a person acquires or disposes of shares of a corporation and it can reasonably be considered that the principal purpose for the acquisition or disposition is to permit a person to avoid, reduce or defer any amount payable under the ITA, for the purposes of the foreign affiliate rules the acquisition or disposition is deemed not to have taken place.
In Lehigh, the taxpayers (two Canadian corporations) established a U.S. limited liability company (the "LLC") to which they contributed funds which were loaned by the LLC to a U.S. operating affiliate ("US Opco") – a variation on a relatively common internal financing structure. US Opco paid interest to the LLC and it was intended that under the Canadian foreign affiliate rules the interest would be deemed to be active business income and exempt surplus to the LLC. The LLC used the interest income to pay dividends to the taxpayers. The taxpayers reported on the basis that they received dividends from a foreign affiliate (the LLC) that were exempt from Canadian tax. For U.S. tax purposes, the LLC was a partnership and the interest income of the LLC was allocated to the taxpayers and subject to a 10% U.S. withholding tax. Therefore, from a U.S. tax perspective, the transactions resulted in a reduction of US Opco's operating income by virtue of the interest deductions at the cost of a 10% U.S. withholding tax on the interest received by the LLC.
The Canada Revenue Agency reassessed the taxpayers under paragraph 95(6)(b) arguing that the LLC interests were acquired by the taxpayers principally to avoid tax under the ITA and, therefore, the LLC interests were deemed to not be acquired by the taxpayers for the purposes of the foreign affiliate rules. On this basis, the LLC would not qualify as a foreign affiliate of the taxpayers and the dividends would not constitute exempt dividends.
The Tax Court held that paragraph 95(6)(b) did not apply to the taxpayers on the basis that the transactions were intended to reduce U.S. tax and were not undertaken to avoid tax under the ITA. Although the Tax Court came to a favourable conclusion for the taxpayer in Lehigh, the Tax Court comments on the breadth of paragraph 95(6)(b) are quite controversial. In particular, the Tax Court stated "[a] textual, contextual and purposive analysis leads to the conclusion that the provision can apply to any acquisition or disposition of shares that is principally tax-motivated." Since dividends on shares of foreign affiliates generally receive beneficial tax treatment under the ITA, the acquisition of any share that results in a non-resident corporation becoming a foreign affiliate of a taxpayer could be argued to be tax-motivated and potentially subject to paragraph 95(6)(b). The comments are all the more troubling in that subsection 95(6) has received very little judicial consideration. The Crown has appealed the decision in Lehigh to the Federal Court of Appeal and it is hoped that, whatever the outcome for the taxpayer involved, the Federal Court will limit the scope of these comments made by the Tax Court.
Assumption of reclamation obligations, not proceeds of disposition
In 2013, the Supreme Court of Canada released its decision in Daishowa v. The Queen. Daishowa agreed to sell timber rights which carried with them certain reforestation obligations. The price was $180 million less the preliminary estimate of $11 million for the assumption of the reforestation obligations by the purchaser, which amount would be adjusted based on a final estimate of the reforestation obligations. The Federal Court of Appeal held that the purchaser's assumption of the reforestation liabilities constituted consideration (and additional proceeds of disposition) to the taxpayer and because the parties specifically "agreed to a price of $11,000,000 for the reforestation liability...they should be held to that price for income tax purposes". The Federal Court's decision would have resulted in double taxation because the taxpayer was treated as having received taxable proceeds of disposition in respect of an economic obligation for which it had no deduction or cost for tax purposes.
In overturning the Federal Court of Appeal's decision, the Supreme Court found that the reclamation obligations were "embedded" in the property to which they related and did not constitute a separate liability of the taxpayer. On this basis, the Supreme Court held that the purchaser's assumption of reclamation obligations did not constitute an assumption of a distinct existing liability of the taxpayer and, accordingly, the assumption of such obligations did not constitute additional proceeds of disposition to the taxpayer. The treatment of contingent obligations in purchase and sale transactions can be a thorny issue. The Daishowa decision does not put these issues to rest in general, but it is a welcome and sensible development in the area.
Outlook for Canadian Tax Developments in 2014
The Department of Finance's general policy of secrecy means any predictions about future tax developments can only be guesses. The entirely unforeseen scope of additional tax developments last year is proof of this. With that in mind, we can anticipate that Finance may release final versions of the July 12, 2013 foreign affiliate legislation and the August 16, 2013 foreign affiliate dumping legislation discussed above.
In addition, the Minister of Finance typically delivers the annual budget at the end of March - although there has been recent speculation that the 2014 budget will be delivered in February this year. At the annual tax conference in November 2013, the Department of Finance suggested that the revenue-raising measures in the previous few budgets have been a significant factor in reducing the government's deficit and that taxpayers should expect that the 2014 budget will continue the trend of including measures focusing on "unintended tax preferences". One likely measure is rules that address tax treaty shopping.
Another possible measure is a broadening of the circumstances in which taxpayers are taxed on an accrual basis in respect of FAPI of foreign subsidiaries. Currently, taxpayers are only taxed in respect of FAPI of a foreign subsidiary where the foreign subsidiary is a "controlled foreign affiliate" of the taxpayer. A 2008 government-sponsored advisory panel recommended a number of amendments to Canada's internal tax system. The government has adopted a number of the panel's recommendations (including the 2012 and 2013 amendments to the thin capitalization rules and the foreign affiliate dumping rules). One of the tightening measures considered by the panel was whether the FAPI regime should be extended to apply to certain non-controlled foreign affiliates. It is unclear whether the government is considering possible amendments in this regard.
This article first appeared mondaq.com.