Section 91

Previously no pick-up of FAPI if not a CFA at year end (p. 762)

One surprise in Bill C-43 is that it does not contain a substantial amendment proposed in the summer of 2013….

[F]API) of a "controlled foreign affiliate" (CFA) is attributed to the relevant Canadian resident only if there is CFA status vis-a-vis the Canadian at the end of the taxation year of the CFA….

Analogous U.S. rule (p. 762)

(The U.S. rule in converse circumstances is that pro rata portions of Subpart F income must be recognized unless the disposition occurs in the first 30 days of the CFC's taxable year and the sale is to a non-U.S. person; but for U.S. corporations that pay the same rate of the tax on capital gains and ordinary income, these effects may be neutral.) [fn 34: See Code §951(a). Where a corporation has capital losses that may only be offset against capital gains, the effects would seemingly not be neutral.]

Adoption of FAPI pick-up if disposition before year end (p.762)

An amendment proposed last summer [fn 35: Proposed §91(1.1) and §91(1.2).] would change the 38-year-old rule and adopt the U.S. approach by requiring a FAPI pick-up even if the CFA interest has been disposed of before year end. But this change should have no net effect where the disposed CFA is a U.S. corporation because the usual U.S. corporate tax rate would, pursuant to a de facto (§91(4)) foreign tax credit, eliminate any net Canadian tax on the attributed FAPI. That would preclude any upward basis adjustment (under §92 of the Act) for the Canadian shareholder and thus not affect the determination of the amount of gain upon the disposition.

But, as noted, the amendment is being reworked and is not in Bill C-43.

Deemed year-end for CFA whose SEP increases? (p. 6)

The proposal's charging provision operates whenever – vis-à-vis a particular CFA – there is a decrease in a taxpayer's surplus entitlement percentage (SEP), calculated as if the taxpayer were a Canco. Immediately before the time of the decrease, the CFA has a deemed taxation year-end for the purposes of section 91, and thus the disposing taxpayer must pick up its share of FAPI in the stub period. The deemed year-end rule does not apply if another connected Canco has an equal and offsetting SEP increase vis-à-vis the CFA. It is not clear whether the CFA of a Canco whose SEP increases (the acquiring taxpayer) also has a deemed year-end if that Canco is not connected.

Narrowness of relieving concept of "connected" (pp. 6-7)

The relieving definition of "connected" in the proposal is a concern because it is much narrower than the relieving definition of "specified person or partnership" in the companion provision in paragraph 95(2)(f.1), which uses the concept of non-arm's length. As a result, more than 100 percent of the FAPI in a stub period may be caught in the Canadian tax net, because the disposing and acquiring taxpayers may be related but not connected (as defined for the two companion provisions). Thus, if the CFA does not have a deemed year-end vis-à-vis the acquiring taxpayer because it is related to the disposing taxpayer, the acquiring taxpayer must pick up current-year FAPI in the year of acquisition and before the SEP change (paragraph 95(2)(f.1)). If the disposing taxpayer is not connected with the acquiring taxpayer, the disposing taxpayer must also pick up the same FAPI (proposed subsection 91(1.1)).

Narrowness of connected definition (p. 1275)

[A]ssume that A is a non-resident that owns 100% of the shares of two first tier Canadian holding companies (B and C) and that B and C in turn each own 50% of the shares of another Canadian corporation (D), which owns 100% of the shares of a CFA (F). If D transfers the shares of F to B and C, the exception does not appear to apply as neither B nor C is connected with D under the current draft.

The FAT [foreign accrual tax] or UFT [underlying foreign tax] denied under the FTCG [foreign tax credit generator] Rules is not limited to the amount of foreign income or profits taxes paid in respect of FAPI [foreign accrual property income]. In certain circumstances, the FTCG Rules could deny credit for Canadian taxes paid. FAT and UFT include income or profits tax paid by a foreign affiliate to the government of any country, including Canada. [fn. 11: See the definitions of "foreign accrual tax" in subsection 95(1) of the Act and "underlying foreign tax" in subsection 5907(1) of the Regulations, as well as Canada Revenue Agency Documents 2000-0058637 (February 5, 2002) and Canada Revenue Agency Document 2007-0247551E5 (June 27, 2008).] For example, consider a situation in which a foreign affiliate lends money to a related Canadian resident. The interest paid to the affiliate is subject to Canadian non-resident withholding tax at a rate of 25%. Absent the FTCG Rules, this withholding tax borne by the foreign affiliate should generally be included in the affiliate's FAT and UFT. However, if the FTCG Rules apply to a taxpayer in respect of the affiliate, this withholding tax will be ignored in computing the taxpayer's FAT and UFT deductions, even though it represents actual Canadian taxes paid.

After describing the cross-chain funding rule in draft s. 91(4.1) and Reg. 5907(1.06), they provided this example:

For example, consider a taxpayer that has two foreign affiliates, FA 1 and FA 2. The taxpayer directly owns 100% of the shares of each affiliate (i.e., there is no cross-ownership between FA 1 and FA2). Assume the taxpayer's investment in FA 1 satisfies a hybrid condition. The FTCG Rules will apply to the taxpayer in respect of FA 1, as the taxpayer is a specified owner and FA 1 is a pertinent person or partnership. The rules will not apply to FA 2, because FA 1 is not a pertinent person or partnership of FA 2. However, if FA 1 made a non-interest-bearing loan to FA 2, the cross-chain funding rule would deem FA 1 to be a pertinent person or partnership of FA 2. The taxpayer's investment in FA 2 would then be caught by the FTCG Rules. The cross-chain funding rule would not apply if the loan from FA 1 to FA 2 had arm's length terms and conditions.

No relief where PPOP is the hybrid (p. 1281)

Subsection 91(4.5) does not provide relief, however, where the PPOP itself is the hybrid entity. For example, consider the situation where a taxpayer has the following structure:

1. Pubco, a Canadian corporation, owns all issued and outstanding shares of U.S. Holdco, a U.S. C corporation.
2. U.S. Holdco owns all issued and outstanding units of U.S. LLC.
3. U.S. Holdco earns FAPI in respect of which it incurs U.S. tax.

In this example, the U.S. LLC is disregarded under U.S. law and therefore, U.S. Holdco does not own the shares of U.S. LLC that it owns for purposes of Canadian law. Accordingly, and stepping through the language of the provision, subsection 91(4.1) will deny Pubco its FAT deduction since U.S. Holdco, a "specified owner" in respect of the "taxpayer" Pubco, is considered under U.S. law to own less than all of the shares of U.S. LLC, a "pertinent person" in respect of the "affiliate" U.S. Holdco, that it is considered to own for purposes of the Act….

Unlike the August 2010 Proposals, the exception for the hybrid entities in the current FTCG [foreign tax credit generator] Rules only applies to the investor entity, not to the entity which receives the investment. Thus, if an entity is treated as a corporation under Canadian tax law but is treated as an entity without share capital under the relevant foreign tax law, an investment in this entity could be considered a hybrid investment that is subject to the FTCG Rules.…When the specified owner concept was introduced in the current rules, Finance may have negledcted to extend the hybrid entity exception to cover both specified owners and the new pertinent person or partnership concept.

…FAT denial does not arise in situations where the specified owner does not own the same number of FA shares in the PPOP [pertinent person or partnership] solely because it is disregarded for foreign (such as US) tax purposes. However, the FTCG proposals deny all FAT in an FA chain if the PPOP is the hybrid entity. Assume, for example, that USco wholly owns a US pass through LLC. Under US tax law, the LLC does not exist, and therefore USco does not own all of the shares that it owns for Canadian tax purposes. Thus, all FAT in this FA ownership chain is denied. (Finance is aware of this anomaly and may be sympathetic to a legislative amendment.) An additional concern arises for an entity (tested as a PPOP) that under foreign tax law does not issue shares (such as a company limited by guarantee) and other non-share entities (such as a limitada or a GmbH that has percentage ownerships or quotas in lieu of actual shares). [emphasis added]

After referring to the expansion of the income test in s. 91(4.1)(a) by virtue of the deductible dividend test in s. 91(4.7), they stated:

… On this basis, the income test could apply to investments that may not be considered hybrid instruments in the conventional sense. For example, dividends paid on certain Australian preferred shares are deductible by the payer, but are still considered dividends for some Australian tax purposes. These types of investments appear to be the subject of the income test addition to the FTCG Rules.

The income test refers to dividends or similar amounts that are treated as "interest or another form of deductible payment" under the relevant foreign tax law. It is not clear whether this rule applies only when amounts are actually paid and deducted, or if it applies whenever an entity has the ability to make deductible distributions in respect of shares.…

For example, Brazilian law allows incorporated companies to pay pro rata distributions referred to as "interest on equity." These distributions generally are deductible under Brazilian tax law, up to a maximum amount based on the company's "equity" and certain prescribed interest rates. These payments are deductible when declared, but a company can choose not to claim the deduction. Based on the words, the income test could apply when a Brazilian company makes an interest on equity payment, even if it chooses not to deduct this payment.

Under some foreign tax laws, dividends or similar amounts in respect of an FA are either tax-deductible interest payments or other deductible payments; in that case, the specified owner of those shares is deemed to own less than all of the shares of that PPOP [pertinent person or partnership]. This situation may occur, for example, if a taxpayer or an FA in an FA chain owns redeemable preferred shares of an Australian corporation; those shares may be treated like debt under Australian tax law. The perceived mischief may arise because the dividend paid is tax-deductible in Australia but a receipt is exempt surplus for Canadian tax purposes. Unfortunately, this same provision may catch most commercial conduct entities that are FAs, such as US REITs, REMICs, RICs, and co-ops. Brazilian interest-on-equity shares and UK LLPs may also be adversely affected. Belgian and Italian notional interest deduction regimes are generally considered not to be vulnerable.

Discussion of various deficiencies in s. 91(5) (at pp. 43:7-43:8)