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CANADIAN AND CANADA/U.S. CROSS-BORDER TAX UPDATE 6 th Annual Dallas TEI Canadian Tax Luncheon February 24, 2015 – The City Club Bryan Bailey, Partner Chris.

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Presentation on theme: "CANADIAN AND CANADA/U.S. CROSS-BORDER TAX UPDATE 6 th Annual Dallas TEI Canadian Tax Luncheon February 24, 2015 – The City Club Bryan Bailey, Partner Chris."— Presentation transcript:

1 CANADIAN AND CANADA/U.S. CROSS-BORDER TAX UPDATE 6 th Annual Dallas TEI Canadian Tax Luncheon February 24, 2015 – The City Club Bryan Bailey, Partner Chris Van Loan, Partner

2 Back-to-Back Loan Rules First proposed in 2014 federal budget; revised proposals in August and October 2014 Now law (no grandfathering) Anti-avoidance rules designed to prevent taxpayers from circumventing Canada’s withholding tax and thin capitalization rules 2

3 Cross-Border Debt: Withholding Tax Generally, no Canadian withholding tax on interest paid by Canadian borrower to “arm’s length” (e.g. unrelated) foreign lender Generally, there will be Canadian withholding tax on interest paid to “non-arm’s length” (e.g. related) foreign lenders (25% domestic rate; generally reduced to 10% by treaty) –complete exemption may be available for qualifying persons under Canada-U.S. treaty and Canada-U.K. treaty Take away: related party lender, generally withholding tax 3

4 Cross-Border Debt: Thin Cap Canadian thin capitalization rules limit deductions for interest where Canadian borrower is too thinly capitalized by “specified non-residents” –non-residents who hold, or do not deal at arm’s length with entities that hold, 25% of votes or value of borrower –1.5:1 debt/equity ratio Deduction for interest on excessive debt is denied and is deemed to be a dividend subject to withholding tax (so this matters to US lenders) Take away: related party lender, thin cap concerns 4

5 Back-to-Back Loan Rules – Objective Prevent taxpayers from interposing an intermediary (e.g. arm’s length bank) between Canadian borrower and foreign parent lender to circumvent withholding tax and thin cap rules 5

6 Example direct loan: –10% withholding tax on interest –“bad” debt for thin cap indirect loan: –0% withholding tax on interest –Existing thin cap “indirect loan” rule; concerns that it is not broad enough Franceco Canco Netherlands Bank loan 100% 6

7 Specific Requirements One set of rules for thin cap; one set for withholding tax; broader than expected Basic requirements (thin cap) 1.Canadian borrower owes amount to intermediary – “primary debt” 2.(a) intermediary owes amount to specified non-resident (e.g. borrower parent) – “secondary debt” –secondary debt is “limited recourse” or there is “link” between primary debt and secondary debt OR 7

8 Specific Requirements (cont’d) (b) “specified right” in a property is granted by specified non-resident to intermediary –specified right means a right to mortgage, assign, pledge or encumber property to secure payment of a debt (other than primary debt) or to use, invest or sell property (unless all proceeds first used to repay primary debt) If rules apply, primary debt (to the extent of the amount of secondary debt or FMV of specified right) will be deemed “bad debt” for thin cap 8

9 Specific Requirements (cont’d) Similar requirements for withholding tax purposes, with an additional requirement that withholding tax on interest would be greater if interest paid by Canadian borrower directly to non-resident (instead of intermediary) If rules apply, deemed payment of interest by Canadian borrower to non-resident 9

10 Example – Specified Right – Caught by Rules securities dealer has right to pledge or assign securities and full discretion over use of proceeds $50 m is “bad debt” for thin cap; maybe no withholding tax issue unless LOB provision of lien on Forco property to secure $50 m loan/provision of secured guarantee by Forco not caught $50 m loan Forco (US parent) Canco Bank Bank Sub/ Securities Dealer $50 m marketable securities 10

11 Example – Indirect Treaty Shopping Rule Caymanco USco Canco $50 m loan 11 rules apply because “link” between loans for withholding tax purposes, non-arm’s length non-residents not excluded as intermediaries deemed interest payment by Canco to Caymanco (25% withholding)

12 Example – Cash Pooling and De Minimus Rule total borrowings cannot exceed 20M + cash deposit amounts all amounts placed on deposit with bank by net lenders secure payment of all amounts lent by the bank to net borrowers Forco Canco Bank Forco1 $80 m deposit $40 m loan $60 m loan 12 back-to-back loan rules apply safe harbour available if amount provided to intermediary (secondary debt/FMV of specified right) < 25% of primary debt –in addition to primary debt, include debt owing by related borrowers under same or connected agreement, where security provided secures all debt obligations –intended to provide relief where multiple cross-collateralized debts owing to intermediary by multiple group entities safe harbour not available in this example

13 Cash Pooling – Other Possible Canadian Tax Issues 13 Additional tax considerations are involved where the pooling arrangements involve foreign subsidiaries of a Canadian taxpayer (i.e., downstream ) or transactions between such foreign subsidiaries and foreign sister corporations of the Canadian taxpayer This slide illustrates the types of indebtedness that may result from a cash pooling arrangement involving a foreign affiliate of the Canadian taxpayer These loans could have a number of Canadian tax implications including the following: the application of the upstream loan rules foreign accrual property income (“FAPI” considerations) deemed interest inclusion under section 17 Application of the foreign affiliate dumping rules NR Co Canco FA1 Loan 1 NRSub Loan 4 Loan 2 Loan 3

14 Cash Pooling – Upstream Loans 14 The upstream loan rules were intended to prevent foreign affiliates of Canadian taxpayers from making loans of taxable or hybrid surplus to a Canadian taxpayer The rules, however, have broader application Generally, the rules are potentially applicable where a “specified debtor” becomes indebted to a foreign affiliate of the taxpayer (a “creditor affiliate”) A “specified debtor” is generally the Canadian taxpayer, a person that does not deal at arm’s length with the taxpayer other than a “controlled foreign affiliate” for purposes of section 17 NR Co Canco FA1 Loan 1 NRSub Loan 4 Loan 2 Loan 3

15 Cash Pooling – Upstream Loans 15 If applicable, the upstream loan rules could result in an income inclusion based on the amount of the loan Each of Loans 1, 2 and 3 could give rise to an upstream loan concern A cash pooling arrangement where a “creditor affiliate” deposits an amount with a bank that also makes a loan to a “specified debtor” could be caught by these rules as well pursuant to a “back-to-back loan” provision included in subsection 90(7) NR Co Canco FA1 Loan 1 NRSub Loan 4 Loan 2 Loan 3

16 Cash Pooling – Upstream Loans 16 There are exceptions available including loans or indebtedness repaid within two years from the day the loan was made or indebtedness arose, provided repayment is not part of a series of loans or other transactions and repayments (paragraph 90(8)(a)) Indebtedness that arose in the ordinary course of business of creditor or loan made in ordinary course of creditor’s ordinary course of business of lending money, provided bona fide arrangements made for repayment within a reasonable time (paragraph 90(8)(b)) There is also an annual deduction/reserve which generally may be claimed each year during which loan is outstanding to the extent that at the time the loan was made, the creditor affiliate could have paid up an amount as a dividend that would have been eligible for a deduction under certain provisions of subsection 113(1) or under subsection 91(5) NR Co Canco FA1 Loan 1 NRSub Loan 4 Loan 2 Loan 3

17 Cash Pooling – Foreign Accrual Property Income 17 Any interest earned by FA1 from Loans 1, 2 or 3 would likely be considered to be “foreign accrual property income” (“FAPI”) Any such FAPI would be subject to tax in Canco’s hands in the year in which it was earned regardless of whether the income was distributed to Canco Interest on these loans would not be eligible to be recharacterized as “income from an active business” pursuant to sub- paragraph 95(2)(a)(ii) NR Co Canco FA1 Loan 1 NRSub Loan 4 Loan 2 Loan 3

18 Cash Pooling – Deemed Interest Inclusion 18 Each of Loans could result in a deemed interest inclusion to Canco pursuant to section 17 The amount of each such inclusion is reduced by the amount that would otherwise have been included in FA1’s FAPI If NRSub had been another controlled foreign affiliate of Canco, an exception to this rule would have been available under paragraph 17(3)(a) with respect to Loan 3 NR Co Canco FA1 Loan 1 NRSub Loan 4 Loan 2 Loan 3

19 Cash Pooling – Foreign Affiliate Dumping 19 Loan 4 could result in the application of the “foreign affiliate dumping” rules under section An exception may be available if the loan was a “pertinent loan or indebtedness” (“PLOI”) The loan was made in Canco’s “ordinary course of business” A CRA administrative position suggests that a loan made under a cash pooling arrangement may be considered to be made in a taxpayer’s ordinary course of business (see CRA document C6) If the foreign affiliate dumping provisions are applicable, the “paid-up capital” of Canco would either be reduced by the amount of the loan or Canco could be deemed to have paid a dividend subject to withholding tax to NR Co (or a combination of both) NR Co Canco FA1 Loan 1 NRSub Loan 4 Loan 2 Loan 3

20 Income Tax Issues Relating to Foreign Currency-Denominated Debt Fluctuations in the value of currencies relative to the Canadian dollar can have significant income tax implications With the strengthening of the Canadian dollar against the U.S. dollar, the issue of foreign exchange-related gains and losses will be a significant Canadian income tax issue In the spring of 2012, CDN$1was worth US$1.02 while it is worth just over US$0.80 today 20

21 Income Tax Issues Relating to Foreign Currency-Denominated Debt (Cont’d) Because of the significant income tax consequences these changes in exchange rate can have on a taxpayer’s income tax liability, we have seen a number of changes to the Canadian income tax provisions –functional currency election –a number of changes to the foreign affiliate rules generally designed to minimize the impact of foreign exchange fluctuations 21

22 Income Tax Issues Relating to Foreign Currency-Denominated Debt (Cont’d) Subject to the functional currency rules, taxpayers in Canada are required to determine their income tax results in Canadian dollars Where gains and losses relate to foreign exchange fluctuations are ordinary business items, such gains and losses will be fully included in (deducted from) income 22

23 Income Tax Issues Relating to Foreign Currency-Denominated Debt (Cont’d) Where the foreign exchange gains and losses relate to a capital gains asset or capital liability, only one-half of the gain or loss is included (or deducted from) income Where a borrowing is part of the taxpayer’s fixed or permanent capital rather than circulating capital, then such debt will generally be considered to be on capital account 23

24 Income Tax Issues Relating to Foreign Currency-Denominated Debt (Cont’d) Subsection 39(2) provides that an issuer of a debt obligation denominated in a foreign currency will realize a gain or loss based on foreign exchange fluctuations from the time the debt was issued until it was repaid or settled Subsection 111(12) [provides that] where there has been a loss restriction event of certain taxpayers (e.g., an acquisition of control of a corporation), unrealized foreign exchange losses on a debt issued by the taxpayer would have to be recognized while the taxpayer could elect whether or not to recognize a foreign exchange-related gain 24

25 Agnico-Eagle Mines v. The Queen Canadian corporation issued U.S. dollar convertible debentures in 2002 Holders had a right to convert the debentures into a fixed number of common shares of the issuer. The conversion price of US$14 per share represented a premium over the US$12.68 trading price at the time the debentures were issued 25

26 Agnico-Eagle Mines v. The Queen (Cont’d) When the issuer announced it would redeem the debentures in February 2006, the overwhelming majority of debenture holders opted to convert into common shares which were trading in a range from US$14.63 to US$24.15 All debenture holders would receive shares with a U.S. dollar amount exceeding the U.S. dollar principal amount of the convertible debentures 26

27 Agnico-Eagle Mines v. The Queen (Cont’d) At the time the debentures were issued, the exchange rate was CDN$ per U.S. dollar. The Canadian dollar strengthened during this time and the exchange rate was between CDN$ to CDN$ per U.S. dollar when holders converted The strengthening of the Canadian dollar over the term of the debentures meant that the U.S. dollar principal amount of the debentures could have been satisfied with fewer Canadian dollar than would have been the case at issuance 27

28 Agnico-Eagle Mines v. The Queen (Cont’d) These were convertible debentures, however, and the fair market value of the shares issued on conversion measured in Canadian dollars exceeded the Canadian dollar amount of the U.S. dollar debentures at the time they were issued The Canada Revenue Agency (the “CRA”) assessed the taxpayer with CDN$62 million capital gain pursuant to subsection 39(2) of the Income Tax Act (Canada) 28

29 Example 29 US$ US$:CDN$ CDN$ Issue amount of debentures US$1,000 1: CDN$1,588 Principal amount at time of conversion US$1,000 1: CDN$1,144 Fair market value of 71 fixed number of common shares issued on conversion (assuming US$24.15 trading value) US$1, CDN$1,962  Canadian dollar equivalent of principal amount at conversion is less than at issuance: CDN$1,588 – CDN$1,144 = CDN$444  Canadian dollar equivalent of shares used to repay is more than at issuance: CDN$1,588 – CDN$1,962 = (CDN$374)

30 Tax Court of Canada Decision The Court confirmed the amount to be repaid on repayment of a debt is translated into Canadian dollars computed at the date of repayment The Court stated that it was less clear what the appropriate translation date should be for determining the amount paid on a conversion of a debt obligation Case law relating to what the cost of property to a corporation should be where the consideration was in the form of shares 30

31 Tax Court of Canada Decision (Cont’d) Generally, the “true consideration” is generally determined by the amount added to the corporation’s stated capital account. It may also be reflected in what was added to the stated capital account monitored for the shares The Court concluded that the “true consideration” for the issuance of the common shares issued on the conversion of the debentures was based on the exchange rate at the time that the debentures were issued Thus, the convertible debentures were considered to have been “repaid” for the same Canadian dollar equivalent as they were issued 31

32 CRA Position on Foreign Currency Hedging Profits and losses from derivative transactions, including foreign currency swaps and foreign currency forward transactions, are generally on income account The CRA takes the position that, in order to be on capital account, the hedge must be sufficiently “linked” to “an underlying transaction” that is on capital account In this regard, the CRA generally requires that the notional amounts inception dates and maturity dates of the derivative transactions correspond to the underlying transaction This position is based on the Supreme Court of Canada decision in Shell Canada Limited v. The Queen, which concerned a “weak currency loan” structure 32

33 George Weston Limited v. The Queen Tax Court of Canada decision released on February 19, 2015 Taxpayer had entered into foreign currency swaps to “protect its consolidated group equity” Taxpayer had a formal derivative policy prohibiting it from speculating in derivatives Evidence in financial statements and corporate records that taxpayer had entered into the swaps in a careful and systematic manner to hedge its currency risk associated with its investment in U.S. operations 33

34 George Weston Limited v. The Queen (Cont’d) Court looked at the taxpayer’s intention at the time that it entered the swaps and concluded the taxpayer’s intention was to hedge currency risk associated with the effect that Canada/U.S. dollar fluctuations were having on the taxpayer’s debt to equity ratio as a result of its investment in U.S. operations The swaps were entered into to circumvent currency risk and protect its consolidated group equity; not for reasons of speculation This decision will be welcomed by many taxpayers 34

35 Exchangeable Shares: Introduction Used in acquisitions of Canadian public or private corporations where consideration consists (in whole or in part) of shares of non- Canadian acquiror Principal purpose is to provide Canadian resident shareholders with tax-deferred rollover on share exchange No rollover is available for Canadian tax purposes where shares of a Canadian corporation are exchanged for foreign shares –rollover generally available when Canadian shares are exchanged for shares of Canadian corporation –accordingly, instead of issuing shares of foreign acquiror, exchangeable shares of a Canadian acquisition entity are issued to Canadian sellers –exchangeable shares are "economically equivalent" to, and exchangeable for, shares of foreign acquiror 35

36 36 Exchangeable Shares - Typical Structure Forco Canada Callco Canada Exchangeco Canada Target Canadian resident sellers exchangeable shares Canadian sellers sell Canada Target shares to Canada Exchangeco for shares of Canada Exchangeco; non- Canadian sellers (and Canadian tax-exempts) typically sell Canada Target shares in exchange for Forco shares tax elections required for rollover under this structure; can be an administrative nuisance for Canadian public co target

37 Attributes of Exchangeable Shares Share terms contain retraction right which allows holder to require Canada Exchangeco to redeem exchangeable shares at any time in exchange for Forco shares –less favourable "deemed dividend" treatment if exchangeable shares redeemed (generally higher tax rate for holders; Part VI.1 tax for issuer) –accordingly, Forco or Canada Callco has overriding call right to purchase exchangeable shares on receipt of retraction notice 37

38 38 Exercise of Overriding Call Right Forco Canada Callco Canada Exchangeco Canada Target Canadian resident seller exchangeable shares Delivery of retraction notice 2Callco exercises call right; Forco subscribes for shares of Callco; subscription price satisfied by delivery of Forco shares 3Callco delivers Forco shares to Canadian seller in consideration for exchangeable shares capital gains treatment instead of deemed dividend treatment use of Callco to generate cross-border paid-up capital

39 Attributes of Exchangeable Shares (cont’d) Share terms contain dividend rights which entitle holders to dividends equal to dividends on Forco shares –receipt of dividends from Canadian corporation is another potential advantage for Canadian sellers –however, can be issues if dividends paid (Part VI.1 tax for issuer) Automatic redemption dates: outside “sunset” date (5-12 years); if small percentage of exchangeable shares outstanding (15%) Right to receive Forco shares on liquidation of Canada Exchangeco 39

40 Ancillary Rights to Provide Equivalence Holder granted rights to vote shares of Forco; special voting share issued to trustee Holders granted right to put exchangeable shares to Forco in event of Forco insolvency event Voting and put right contained in “voting and exchange” agreement; represent "boot" (position taken is that "boot" has nominal value) Support agreement under which Forco covenants to fund Canada Exchangeco to pay equivalent dividends and to deliver Forco shares on redemption/retraction events 40

41 Derivative Forward Agreements Character conversion rule treats the gain (or loss) realized on a purchase or sale of capital property under a “derivative forward agreement” as ordinary income (or loss) rather than capital gain (or loss) The new rules were directed at funds that have used forward contracts or derivative contracts to convert ordinary income into capital gains 41

42 Derivative Forward Agreements (Cont’d) A derivative forward agreement is defined to include any agreement to purchase or sell capital property where: (a)the term of the agreement or a series of agreement exceeds 180 days, and (b)in the case of a purchase agreement, the difference between the fair market value of property to be delivered on settlement, including partial settlement, of the agreement and the amount paid is attributable, in whole or in part, to an underlying interest (including a value, price, rate, variable, index, event, probability or thing) other than: (i)revenue, income or cash flow in respect of the property over the term of the agreement, changes in the fair market value of the property over the term of the agreement, or any similar criteria in respect of the property, or (ii)where the purchase price is denominated in the currency of a country other than Canada, changes in the value of the Canadian currency relative to that currency, 42

43 Derivative Forward Agreements (Cont’d) (c)in the case of a sale agreement, (i)the difference between the sale price of the property and the fair market value of the property at the time the agreement is entered into by the taxpayer is attributable, in whole or in part, to an underlying interest (including a value, price, rate, variable, index, event, probability or thing) other than (A)revenue, income or cash flow in respect of the property over the term of the agreement, changes in the fair market value of the property over the term of the agreement, or any similar criteria in respect of the property, or (B)where the sale price is denominated in the currency other than Canada, changes in the value of the Canadian currency relative to that other currency, and (ii)the agreement is part of an arrangement that has the effect – or would have the effect if the agreements that are part of the arrangement and that were entered into by persons or partnerships not dealing at arm’s length with the taxpayer were entered into by the taxpayer instead of non-arm’s length persons or partnerships – of eliminating a majority of the taxpayer’s risk of loss and opportunity for gain or profit in respect of the property for a period of more than 180 days 43

44 Derivative Forward Agreements (Cont’d) Paragraph 12(1)(z.7) includes amounts in income –for a purchase, the amount by which the fair market value of the property exceeds the cost of the property –for a sale, the amount by which the proceeds of disposition of the property exceeds the fair market value of the property at the time that the agreement is entered into Paragraph 20(1)(xx) provides for a deduction (subject to certain restrictions) equal to –for a purchase, the amount by which the cost of the property exceeds its fair market value at the time it is acquired by the taxpayer –for a sale, the amount by which the fair market value of the property at the time the agreement is entered into exceeds the proceeds of disposition of the property Corresponding adjustments to adjusted cost base prevent double counting 44

45 Derivative Forward Agreements and Exchangeable Shares The explanatory notes that accompanied the introduction of the derivative forward agreement rules should not be an issue The basis seemed to be that the exchange right was embedded in the terms of the shares Recall, however, that there are typically separate put and call rights 45

46 Derivative Forward Agreements and Exchangeable Shares (Cont’d) The CRA addressed the issue at the Canadian Tax Foundation’s Annual Conference in November 2014 The CRA was asked to confirm that an example exchangeable share structure does not give rise to a derivative forward agreement because of the embedded exchange right The CRA would not confirm that, but stated instead that the risk of loss or opportunity for profit was not eliminated and, hence, the example exchangeable share structure did not meet the requirements of (c)(ii) of the definition This means that typical exchangeable share structure should not be a concern That being said, care should be taken to ensure that the exchange feature is part of the terms of the share 46

47 Presenters’ Contact Information Chris Van Loan Tax Partner address: Direct Tel. No.: (416) Fax No.: (416) Bryan Bailey Tax Partner address: Direct Tel. No.: (416) Fax No.: (416) Blake, Cassels & Graydon LLP Barristers & Solicitors Patent & Trade-mark Agents 199 Bay Street Suite 4000, Commerce Court West Toronto, Ontario M5L 1A9 Canada 47


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