Raj Juneja, Pierre Bourgeois, "International Tax Issues That Get in the Way of Doing Business", 2019 Conference Report (Canadian Tax Foundation), 36:1 – 42

FAD rules apply even where no debt dumping or surplus stripping involved

  • The foreign affiliate dumping (FAD) rules were intended to target two types of transactions:
    • debt dumping (for example, Canadian Opco borrows to acquire preferred shares of a non-resident Opco subsidiary of its non-resident parent and receives (s. 113(1)(a)) exempt dividends on those shares) (pp. 36:2-3)
    • surplus stripping (for example, Canadian Opco, with distributable cash but whose shares have low paid-up capital (PUC), purchases (or subscribes for) such preferred shares) (pp. 36: 3-4)
  • The principal issue with the FAD rules is that one general rule was drafted to target these two different abuses, and without any purpose test or attempt to narrow the types of investments that are caught, so that they apply where the CRIC makes an investment in an FA regardless of whether any debt dumping or surplus stripping occurs (p. 36:5).
  • For example, they apply where the Canadian subsidiary uses cash on hand to invest in common shares of a wholly owned non-resident Opco for use in its foreign active business – even though there is no debt dumping or surplus stripping involved (p. 36:5).

Exception unavailable where CRIC has no Cdn business

  • It is unclear why it is necessary to meet all of the requirements of the s. 212.3(16) “closely connected business exception” where there is no debt dumping or surplus stripping. For example, where a Canadian public corporation with no operations in Canada becomes a CRIC on being acquired for cash by a foreign multinational, it cannot satisfy that exception because it does not carry on business itself - even if its executives have sole decision-making authority respecting the foreign Opcos. If a “bump and run” transaction could not be structured, this has caused potential foreign acquirors to abandon Canadian acquisitions (pp. 36: 6-7).

Not engaged merely by support agreement or arrangement agreement

  • The entering into of a support agreement or an arrangement agreement prior to implementing an acquisition of a Canadian target should not be considered to be the granting of s. 251(5)(b) rights until the shareholders have tendered their shares or approved the transaction (p. 36: 7).

S. 212.3(10)(f) can encourage bump and run transactions

The structure resulting where a Canadian public corporation, that has no operations in Canada, is acquired by a Canadian Acquisitionco as described in s. 212.3(10)(f), is undesirable since the PUC of the shares of Canadian Acquisitionco is reduced to nil pursuant to ss. 212.3(2) and (7), so that any investment (other than by way of PLOI) made in a foreign Opco by Canadian Public Corporation or Canadian Acquisitionco would result in a deemed dividend by Canadian Acquisitionco to the foreign multinational. Accordingly, the FAD rules encourage a bump-and-run transaction (entailing an amalgamation of Canadian Acquisitionco and Canadian Public Corporation and a bump of the cost of the foreign Opco shares under ss. 87(11), 88(1)(c) and (d)), which provides no benefit to Canada (pp. 36: 7-8).

Uncertainty regarding specified right exclusion in multiparty group secured facility

  • Under a multiparty credit agreement, all parties (Foreign Parent, Canadian Subsidiary and Foreign Subsidiary) guarantee the borrowed sums and pledge their assets except that for foreign tax reasons neither subsidiary guarantees debt of Foreign Parent. Some practitioners have been concerned, regarding the exclusion at the conclusion of the “specified right” definition, that it is insufficiently clear that “all of the proceeds” from a realization on Foreign Parent’s pledge must first be applied to reduce amounts described in s. 18(6)(d)(i) or (ii). Can the proceeds realized under that pledge be applied to the debt of Foreign Subsidiary viewed as debt described in s. 18(6)(d)(ii)? “The uncertainty arises because the debt of Foreign Subsidiary appears to be a debt obligation referred to in clause 18(6)(d)(ii)(A), but not every security interest securing the debt of Foreign Subsidiary secures every other debt obligation under the credit facility, which is required by clause 18(6)(d)(ii)(B).” (pp. 36: 9-10)

Withholding even where subcontracting by NR to Cdn subs

  • A non-resident commonly contracts to provide services to a Canadian resident, and subcontracts the performance of any services that are required to be provided from within Canada to Canadian subsidiaries. Reg. 105 would require withholding on payments to the non-resident person for the portion thereof respecting the services provided from within Canada by the Canadian subsidiaries. (p. 36: 11)

Potential double-withholding where NR subcontractors

  • Where a non-resident service provider subcontracts with other non-residents to provide services in Canada, Reg. 105 withholding could be required on payments to the first non-resident servicer provider and on the payments, in turn, by it to the non-resident subcontractors. This commonly occurs in information technology consulting arrangements. (p. 36: 11)

Allocation difficulties where bundled contracts

  • A commercial contract may provide for a bundle of goods and services – for example, a Canadian business that is operating on-premises enterprise-resource-planning software and pays a flat monthly licence fee under a contract that includes a warranty, where a service provider may be required to deploy personnel to the Canadian business to provide support services. (p. 36: 12)

CRA current use test

  • In 2002-0013899, concerning a taxpayer which carried on transactions to ensure that the conditions under s. 95(2)(a)(ii)(D) applied on an ongoing basis, CRA stated that “[a]s in the case of paragraph 20(1)(c), our position is that the current eligible use of the funds is the key, not the former in-eligible use.” (p. 36: 20)

Potential override by s. 20(3) of a current use test

  • Where the original borrowing or indebtedness is for an ineligible use, any refinancing of this borrowing or indebtedness could continue to be offside by virtue of s. 20(3). (p. 36: 20)

Circularity element in determining excluded property status where material upstream loans

  • Where an acquisition target is a holding company that has numerous operating subsidiaries that have made substantial upstream loans to it, an element of circularity can arise in determining whether the shares of such operating subsidiaries and, thus, the shares of the holding company, are excluded property. (p. 36: 20-21)

Potential multiplier effect of bad assets in a multi-tier structure

  • Due to an upward cascading effect in a multi-tier structure of FAs, a non-resident target with non-excluded property of only 3% on a consolidated basis nonetheless might not have its shares qualify as excluded property. It may be possible to engage in purification transactions to achieve excluded property status. (pp. 36: 21-22)

Need to avoid assumption of liabilities on the drop-down transaction in a “pack and sale” transaction

  • Reg. 5907(2.01) to some extent accommodates “pack and sale” transactions (respecting a drop down of a business unit to a foreign Newco followed by an arm’s length sale of the Newco) by rendering Reg. 5907(5.1) inoperative to transactions occurring on a rollover basis under the foreign tax law (so that exempt surplus may be generated) if certain conditions are met, one of which is that the only consideration received in respect of the particular disposition is shares of the capital stock of another FA of the taxpayer. Thus, the assumption of liabilities on the drop-down transaction would exclude access to Reg. 5907(2.01). See 2014-0550451E5. (p. 36: 33)