15 May 2019 IFA Finance Roundtable
This provides abbreviated summaries some of the oral responses provided at the IFA Finance Roundtable held on 15 May 2018 in Montreal, along with providing the text of the slides posing (or essentially posing) the related questions. The Finance Canada speakers were:
Ted Cook, Director General, Tax Legislation Division
Stephanie Smith, Senior Director, Tax Treaties
The moderators were Jonathan Greb (Baytex Energy) and Claire Kennedy (Bennett Jones).
The questions not provided and the responses not summarized relate to questions of a more general nature e.g., respecting how policy is formulated.
Proposed s. 247(1.1)
Question Headings (from Slide)
Budget 2019 transfer pricing measure
- Intention of proposed subsection 247(1.1)
- Interaction of proposed subsection 247(1.1) with certain provisions in Part I of the ITA:
- 17(1) – amount owing by non-resident
- 18(1)(a) – general limitation on deductions
- 18(4) – thin cap rules
- 85(1) – rollover
Intention of s. 247(1.1)
Cook: Ted indicated that, notwithstanding a suggestion made earlier that s. 247(1.1) was intended to increase transfer-pricing adjustments penalties, that was not the case. If that indeed had been the intention, it could have been accomplished in a more direct way.
There was ambiguity as to the ordering of the respective operations of Parts I and XVI.1. Consider, for example, where a management fee paid by a Canadian taxpayer to a non-arm’s-length non-resident is found to be inappropriate. That could trigger s. 247, but it could also trigger s. 18(1)(a) on the grounds that the fee was excessive or not paid for the purpose of earning business income. Such ambiguity has generated disputes. The Budget 2019 measure establishes that the operation of the transfer rules occurs as the first step. This is a sensible approach, as s. 247 adjusts the tax base, and the tax base should be set before other types of adjustments are applied.
Finance has heard the tax community’s concerns about circular interactions between s. 247 and other parts of the Act, and is looking into this issue.
Smith: Stephanie provided an example of how Part XVI.1 would apply first, followed by the application of other provisions, in this example, s. 17(1). Canco holds an outstanding loan of a non-resident. First it should be determined whether to include, in Canco’s income, interest that would have been so included had the parties dealt arm’s length. If necessary, and assuming that the exception that has already been provided for, and was not otherwise changed in the proposal in s. 247(7), does not apply, there could be an adjustment to include an amount in Canco’s income. The second step is to apply Part I – s. 17 in this case.
Consider a Canco holding a non-interest-bearing loan of a non-resident (which is not a controlled foreign affiliate) that has been outstanding for more than a year. Had the parties been dealing at arm’s length, the loan would have borne a 3% annual interest rate. Part XVI.1 would then include such imputed interest in Canco’s income. The computation in s. 17(1) would then use that same amount in setting item A of the s. 17(1) formula. Thus, where the prescribed rate is less than the arm’s-length rate, there would be no additional income inclusion under s. 17 (as is the case in this example, because the prescribed rate is 2%).
Smith: To be clear, Finance’s intention is not to impose an obligation on taxpayers to analyze what is an arm’s-length capital structure where there was not already such an obligation.
As an example of an interaction, suppose that Canco pays $5 million of interest to a non-arm’s-length non-resident, based on an outstanding debt of $100 million and a 5% interest rate, and it is found that an appropriate arm’s-length interest rate would have been 3%, for $3 million of interest. Under s. 247(2), $2 million of Canco’s deduction would be disallowed.
The next step is to turn to Part I. Suppose also that Canco has $60 million in equity, meaning its debt-equity ratio is about 1.67:1, which exceeds the 1.5:1 ratio in s. 18(4) by approximately 1/10. S. 18(4) therefore denies 1/10 of the deduction of the interest, which is the $3 million amount determined under s. 247, so that approximately $300,000 of interest deduction is denied under s. 18(4).
Smith: Finance would not normally expect an upward adjustment under Part XVI.1 to have tax consequences to a Canadian corporation under s. 85. If someone can demonstrate a bad interaction between Part XVI.1 and s. 85, Finance would be happy to look into it.
Treaty Rate of Withholding Tax
Can Finance confirm its policy is to pursue a 5% withholding rate on non-portfolio dividends in tax treaty negotiations?
Smith: Canada’s policy remains that it will seek a 5% withholding rate on non-portfolio (direct) dividends in its treaties. Where that withholding rate is not included in a Treaty, there are several possible reasons. One is that this is simply a result of the negotiation – some countries (e.g., poorer countries) prefer a higher rate.
Another is where we are re-negotiating for a specific purpose, and the withholding rate is outside the negotiation’s scope. For example, we recently conducted negotiations to update our exchange-of-information protocols with some partners. We may also see some limited negotiations to apply some BEPS-like standards to countries not participating in BEPS.
With the potential replacement of NAFTA by the CUSMA, the proper operation of derivative benefits provisions in some of US’s tax treaties (which require equivalent beneficiaries to be resident in a NAFTA country) may be impeded in respect of foreign affiliates of Canadian MNEs. Has Finance raised this issue with the US Treasury Department?
Smith: The US Treasury is aware of this issue, and there is time to address it before CUSMA comes into force.
Tracking Interest Rules & Umbrella Corporations
Many foreign investment funds are structured as “umbrella corporations”, similar to Canadian multi-class mutual fund corporations, for commercial reasons having nothing to do with Canadian taxes or Canadian investors. The tracking interest rules in subsections 95(8) to (12) enacted by Bill C-86 now must be considered if a Canadian investor owns 10% of a class or series of shares of the umbrella corporation. If the rules apply, a notional separate corporation is to be analyzed. How can a Canadian investor determine who the other shareholders of the notional separate corporation are? How can FAPI be computed? Why not apply section 94.1 to investments in foreign umbrella funds?
Cook: It is not clear to Finance that the compliance burden on a Canadian investor is unusually onerous compared with other compliance obligations under this part of the Act. There is little qualitative difference between the kind of analysis and information that would be required, as between an ordinary and an umbrella corporation, respecting a foreign fund. Moreover, once CFA status has been attained so as to engage a FAPI-reporting obligation, non-resident trusts are already subject to obligations under s. 94.2, and it is not clear that this is different from those other situations.
Following some discussions and consultations with the funds industry and their advisors, the Department recently issued a comfort letter. The comfort letter provides an exception from the tracking interest rules if it cannot reasonably be considered that one of the purposes for the creation or issuance of a tracking interest in an umbrella corporation or for the acquisition of the interest by a taxpayer is to avoid the corporation being a CFA for the year. If the purpose is commercial rather than tax-related, they may be able to avail themselves of an exception from the tracking interest rules.
Regarding s. 94.1, there are a couple of strands to consider. Economic arrangements to avoid CFA status involve not economically pooling the assets with other taxpayers. In contrast, s. 94.1 involves pooling the assets. We see that it may be appropriate to treat a particular sub-fund as a separate notional corporation. This is largely consistent with the scheme of the Act, which first requires the determination of CFA status, and only if the corporation is not a CFA does s.94.1 apply.
This leads to the unusual situation where a taxpayer may prefer to effectively “opt into” s. 94.1 rather than have a tracking interest.