Revised s. 212.1(4) rule generates anomalous results

The exception in s. 212.1(4) from the application of the surplus-stripping rule in ss. 212.1(1) permits the unwinding of a sandwich structure resulting from a Canadian corporate purchaser having acquired a non-resident corporation holding a Canadian subsidiary – so that such non-resident corporation can transfer the shares of the Canadian subsidiary to the Canadian purchaser. The 2016 federal budget proposed a significant narrowing of s. 212.1(4), so that it will not apply where, at any time as part of the series of transactions, a non-resident who did not deal at arm’s length with the Canadian purchaser owned directly or indirectly any share of the purchaser.

Even accepting the general policy of this proposal, it could produce inappropriate results. For example:

• The proposed rule could penalize a Canadian shareholder of the Canadian purchaser if a non-resident shareholder of the purchaser does not deal at arm’s length with the purchaser.
• If a Canadian corporation (with no non-resident shareholders) had previously acquired the purchaser from a non-resident vendor, and the purchaser corporation now is used to acquire a non-resident corporation holding an underlying Canadian corporation, the s. 212.1(4) exception will not be available if the prior acquisition occurred as part of the same "series" - even though no non-resident now indirectly holds any interest in the acquired corporation.
• Similarly, if a Canadian corporation (with no non-resident shareholders) had previously acquired the purchaser from a non-resident vendor, and the purchaser already held a non-resident corporation that, in turn, held an underlying Canadian corporation, s. 212.1(4) will not apply to permit the sandwich to be unwound into the purchaser.
• Where the s. 212.1(4) exception is not available because there is a non-resident corporation atop a double-decker sandwich structure, the unwinding of that structure could result in double withholding tax.
• Purchasers who are Canadian public corporations with non-resident shareholders, or private-equity funds with non-resident partners, may have difficulty in demonstrating satisfaction of the arm’s length test.

Neal Armstrong. Summary of Angelo Nikolakakis, "Cross-Border Surplus Stripping – Stripping Bona Fide Non-Resident Purchasers," International Tax (Wolters Kluwer CCH), No. 87, May 2016, p.4 under s. 212.1(4).