Canada's new foreign investment entity rules

Simon Thompson

On October 30, 2003, the Canadian Department of Finance released a fourth draft of complex tax legislation on the treatment of direct or indirect investments in foreign entities by Canadian taxpayers (FIE Rules). (1) This article updates an article on the third version of the FIE Rules, (2) providing an overview of the revised FIE Rules and issues that tax executives should consider. It is anticipated that the FIE Rules will be passed into law later this year, and will apply retroactively from January 1, 2003.

The Income Tax Act (Canada) (the Act) (3) contains two primary anti-deferral regimes to prevent Canadian taxpayers from earning "passive" income offshore: the foreign accrual property income (FAPI) rules, (4) and the FIE Rules, which replace and significantly expand the offshore investment fund property (OIFP) (5) rules.

The FIE Rules backstop the FAPI rules, which prevent deferral in respect of controlled foreign affiliates (CFAs). (6) Although each of these regimes differ significantly from their parallel regimes in the United States under the Internal Revenue Code (the U.S. Code), the FAPI rules and the FIE Rules have the same general tax policy objectives as the Subpart F and passive foreign investment company (PFIC) rules, respectively.

FIE Rules

A. Basic Charging Rule

Subject to the application of special rules for "tracking interests" and "foreign insurance policies," the FIE Rules apply to a Canadian taxpayer holding a "participating interest" in a "non-resident entity" (NRE) in a particular taxation year of the Canadian taxpayer where: (7)

* the taxpayer is not an "exempt taxpayer" for the particular year;

* the taxpayer holds the interest in the NRE at the end of a taxation year of the NRE that ends in the particular year;

* the NRE is a "foreign investment entity" (FIE) at the end of the NRE's taxation year; and

* the participating interest is not an "exempt interest" at the end of the NRE's taxation year.

If these conditions are all met, the Canadian taxpayer must generally include a specified return in computing income equal to a prescribed interest rate multiplied by the "designated cost" of the participating interest. (8) Subject to certain transitional rules, the "designated cost" will generally be equal to the sure of the participating interest's cost and past amounts included in income under the FIE Rules in respect of the participating interest. If certain conditions are satisfied, the Canadian taxpayer may elect to apply either a mark-to-market regime (9) or an accrual regime rather than the prescribed interest rate regime. The election to apply either the mark-to-market or the accrual regime must be made in respect of the first year in which the FIE Rules will apply (2003, or the first year in which the participating interest is acquired). (10) New rules have been added to prevent many tax-deferred transfers of participating interests in a FIE (other than exempt interests). This prohibition is primarily meant to prevent taxpayers from minimizing the effect of the prescribed interest rate regime, for example, by transferring a participating interest in an NRE shortly before the NRE's year end to a non-arm's length transferee. (11)

The FIE Rules may also result in FAPI to a CFA of a Canadian taxpayer, as a CFA is deemed to be a Canadian taxpayer for purposes of applying the FIE Rules.

B. Analysis of the Basic Charging Rule

1. Participating Interest

A "participating interest" is an equity interest in a corporation, trust, partnership or other entity, an option to acquire such an equity interest, or property convertible into such an equity interest. (12) A participating interest does not include a debt or a derivative contract, unless the contract can be settled through the delivery of a participating interest in an NRE. A new exemption explicitly excludes cash settled derivative contracts. (13)

2. Non-Resident Entity

An NRE means a corporation or a trust that is not resident in Canada for purposes of the Act, (14) or any other entity (such as a partnership) formed or governed under foreign laws. An interest in a partnership, however, is an "exempt interest."

3. Exempt Taxpayer

There are generally three classes of "exempt taxpayers" excluded from the FIE Rules: recent immigrants to Canada (resident in Canada for up to 60 months), most registered pension plans (15) and other persons exempt from Part I tax, (16) and certain Canadian resident trusts in which each beneficiary is exempt from tax. (17)

4. FIE

An NRE is generally considered to be a FIE (18) at the end of a taxation year of the NRE unless either of the following tests is satisfied:

* the carrying value of the NRE's "investment property" is hot greater than 50 percent of the carrying value of all its properties at the end of the year (the "50-percent investment property test"); or

* the NRE's principal undertaking, throughout the year, is the carrying on of a business that is not an "investment business."

Because a determination of FIE status is not made until the end of a NRE's year end, it is impossible to predict with certainty at the time a participating interest in the NRE is acquired whether the NRE will be a FIE. This uncertainty makes it impossible to know whether various rollover rules would apply on transfers of an interest in an NRE (as a rollover may be denied if the NRE is a FIE at year end, even if it would not otherwise have been a FIE at the time of the transfer). Also, as a result of the complexity and form of the FIE Rules and the scarcity of information, many Canadian taxpayers (particularly investors holding minority interests) will be unable to determine (even after a year end of an NRE) whether the NRE is a FIE. In addition, avoiding the application of the FIE Rules may be difficult as the Canada Revenue Agency (CRA) is authorized to demand information (in addition to their normal powers of reassessment) from a Canadian taxpayer requiring the taxpayer to demonstrate to the CRA's satisfaction that an NRE is not a FIE. (19) If the Canadian taxpayer does not provide the requested information within 60 days (or a longer period acceptable to the CRA), the NRE is deemed to be a FIE. The FIE Rules contain several similar administrative overrides that potentially expand the application of the FIE Rules where requested information is hot provided in a timely manner to the CRA.

(a) 50-Percent Investment Property Test. "Investment property" of an NRE includes most passive assets such as shares, debt, real estate, resource property, currency, and derivative financial products. "Investment property," however, does not include:

* property used or held in a business (other than an investment business, as described below); (20)

* certain debt between affiliated corporations, the income from which would be characterized as active business income for FAPI purposes; (21)

* certain property accumulated for a temporary period (generally up to 36 months) for the purpose of a qualifying active use; (22)

* shares issued by the NRE itself; (23) and

* shares and debt issued by "qualifying entities" (described below) in which the NRE has a minimum 25-percent interest. (24)

The "carrying value" of an NRE's property is generally the amount at which the property is valued on a balance sheet prepared in accordance with permissible generally accepted accounting principles (GAAP). (25) A Canadian taxpayer can elect to value property of an NRE at its fair market value, provided the property is on the NRE's balance sheet (e.g., purchased goodwill, but not unpurchased goodwill).

Presumably, consolidated financial statements must be used in determining whether the 50-percent investment property test is satisfied, unless the taxpayer elects to use unconsolidated financial statements (the "Unconsolidated Election"). (26) The general intent of the FIE Rules is to ignore shares and debt owned by an NRE in its affiliates that are not included in its consolidated financial statements for purposes of the 50-percent investment property test. The NRE is considered to own properties owned by affiliates that are included in a consolidated financial statements. (27) In addition, an election may be made to deem an NRE to own a proportionate amount of an affiliate's assets (rather than a participating interest in an affiliate) if the NRE has a direct or indirect significant interest (28) in the affiliate and, if the Unconsolidated Election is hot made, the affiliate is not included in the NRE's consolidated financial statements. (29)

Unfortunately, information on financial statements often may hot be specific enough to determine whether an asset is "investment property" for the purposes of the FIE Rules. Consequently, it will often be difficult to rely solely upon financial statements for determining whether the 50-percent investment property test has been met.

(b) Investment Business Test. An NRE will not be a FIE if its principal undertaking is the carrying on of a business that is not an "investment business" throughout the NRE's taxation year.

An "investment business" is a business (other than an "exempt business") the principal purpose of which is to earn income from property, income from the insurance or reinsurance of risks, income from the factoring of trade receivables, or profits from the disposition of "investment property" (except that the first three exclusions described above do not apply in this case).

An "exempt business" is the business of certain regulated financial institutions, regulated traders and dealers, and certain businesses involving the active management of investment property (e.g., rental of real estate, essentially where services in respect of the real estate are provided by employees of the NRE or related entities). Whether an NRE's principal business is an investment business depends on the facts and circumstances, (30) though the look-through rule used for the 50-percent investment property test applies in a similar manner in connection with determining whether an NRE's principal business is an investment business. (31) The Canadian taxpayer may elect for the principal business determination to be made based on net accounting income (as long as that Canadian taxpayer provides any requested information within 60 days or a longer period acceptable to the CCRA). (32)

5. Exempt Interest

The FIE Rules do not apply to an interest in an NRE that is one of the following types of "exempt interests":

* shares in the capital stock of a CFA of a Canadian taxpayer;

* shares in the capital stock of a "qualifying entity" that is a foreign affiliate of the taxpayer in which the taxpayer has a minimum 10-percent interest by votes and value; (33)

* interests in partnerships;

* participating interests that are "mark-to-market" properties or market-valued inventory of a financial institution; (34)

* certain participating interests acquired in an open market without a defined tax avoidance motive (referred to below as the "Open Market Exemption");

* certain participating interests held by a U.S. citizen that were not acquired with a defined tax avoidance motive; and

* certain participating interests acquired by Canadian taxpayers as employees.

The most important of these categories are described further below.

(a) CFA Exemption. A Canadian taxpayer is required to annually include its proportionate amount of a CFA's FAPI in computing income on an accrual basis. Since the FAPI anti-deferral regime applies to CFAs, it is not necessary for the FIE Rules to also apply.

A Canadian taxpayer may generally elect to have the FAPI regime, rather than the FIE Rules, apply to a foreign affiliate (35) by electing for that affiliate to be treated as a CFA provided the taxpayer has a minimum 10-percent interest (by votes and value) in the affiliate. (36)

(b) Qualifying Entity Exemption. A "qualifying entity" is a partnership or corporation (37) where all or substantially all of the carrying value of its property is attributable to property that is hot "investment property" or certain narrow categories of "investment property." (38) The primary relevance of this exemption is that it accommodates the ownership by an NRE of interests in one or more joint ventures (not carrying on "investment businesses" as previously described) over which the NRE exercises significant influence, in the event that the NRE's percentage interest in such a joint venture does not satisfy the 25-percent "significant interest" test. (39)

(c) Open Market Exemption. The Open Market Exemption will likely be the most relied upon exemption. This exemption is only available in respect of a participating interest of a Canadian taxpayer in an NRE if all of the following conditions are satisfied:

* either (i) the participating interest is of a class of property listed on a prescribed stock exchange and the NRE is resident for purposes of the Act in a country in which any prescribed stock exchange is situated, (40) or (ii) the NRE is resident for treaty purposes in a country with which Canada has entered into a tax treaty (other than a country that is prescribed by regulation) (41) and, in general terms, is governed by the laws of that treaty country;

* at least 150 persons hold identical participating interests, with the interests held by each person having a fair market value of at least Cdn.$500; (42)

* the participating interests can be acquired and sold by members of the public in the open market or can be purchased from or sold to the NRE by a member of the public; (42A)

* the Canadian taxpayer (with non-arm's length parties) owns no more than 10-percent of the participating interests in the class; (43) and

* the participating interest was not acquired or held with any defined tax avoidance motive.

A taxpayer will be considered to have a tax avoidance motive in respect of a participating interest only if it is reasonable to conclude that one of the main reasons for acquiring, holding or having the interest was tax savings or deferral.44 The FIE Rules provide for special exemptions from the tax avoidance motive test for certain NREs (including Regulated Investment Companies and Real Estate Investment Trusts as defined under the U.S. Code).

C. Tracking Interest Rules

The FIE Rules contain broad anti-avoidance rules (the "tracking interest" rules) (45) that are intended to prevent avoidance of the FIE Rules where an investor does not otherwise hold a participating interest in a FIE bat has in substance an economic interest in underlying or notional investment property. For example, these rules ensure the FIE Rules apply to letter stock of an NRE (not otherwise subject to the FIE Rules) that tracks investment property. Although the tracking interest rules are mainly aimed at participating interests with a return linked to discrete passive assets, the rules are extremely broad and are intended to apply even where the return is linked to passive assets not owned by the entity (such as the worldwide supply of gold). In addition, the rules are very complicated and may apply in anomalous situations (particularly as a result of the vague notion of "tracked property").

The tracking interest rules apply to a Canadian taxpayer in respect of a taxpayer's participating interest in an NRE for a particular taxation year where the following criteria are satisfied:

* the FIE Rules do not otherwise apply;

* the taxpayer is not an exempt taxpayer;

* the participating interest is not an exempt interest or is an exempt interest only because of the CFA or Qualifying Entity exemptions;

* the right to receive any payment in respect of the participating interest (or the value of such a right) is, directly or indirectly, determined primarily by specified criteria (including fair market value and profit) in respect of one or more properties (collectively referred to as the "tracked properties" or "tracked property");

* all or substantially all of the fair market value of the tracked property is hot shares of a foreign affiliate of the taxpayer that is a qualifying entity in which the taxpayer has a minimum 10-percent interest by votes and value; and

* the NRE is a "tracking entity" in respect of the participating interest, as described below.

An NRE will be a "tracking entity" if it owns all of the tracked properties, unless one of two exceptions apply. (46) The first exception applies if at least 90 percent of the NRE's property is tracked property. This exception ensures that an NRE issuing common shares will generally not be a "tracking entity" in respect of those shares as a consequence of the return on those shares being considered to track all of the NRE's property. (47) The second exception is where at least 50 percent of the NRE's tracked properties are not "investment property"48 (which would be expected to be the case where letter stock tracks the performance of an active business division of an NRE).

If any one or more of the tracked properties are not owned by the NRE, the only exception from tracking entity status is if it is reasonable to conclude that any investment property owned by the NRE (or an entity that does not deal at arm's length with the NRE), or substituted property, could be used to satisfy the right to receive the tracked property payment. (49)

If the tracking interest rules apply, the taxpayer is required to recognize income in respect of the participating interest under the prescribed interest rate income regime or the elective mark-to-market regime.

D. Effect on the Calculation of FAPI

The FIE Rules may result in FAPI to a foreign affiliate pursuant to draft paragraph 95(2)(g.3) which deems a foreign affiliate (including a CFA) to be a Canadian taxpayer for the purposes of applying the FIE Rules. (50) Additional modifications are also made to the FIE Rules for this purpose, including a rule preventing an NRE from being a CFA of a foreign affiliate. The CFA Exemption from the FIE Rules is only available to the foreign affiliate in respect of shares of the capital stock of a CFA of the Canadian taxpayer (rather than a CFA of the foreign affiliate itself).

Draft paragraph 95(2)(g.3) has been amended to clarify that FAPI will not arise in respect of a CFA holding a participating interest in an NRE that is used or held principally for the purpose of earning active business income. (51)

Comparison To the U.S. PFIC Rules (52)

Although Canada's FIE Rules have the same general tax policy objectives as the U.S. PFIC rules, there are a number of significant differences in the approach taken by the two countries. Very generally, subsection 1297(a) of the U.S. Code provides that a foreign corporation is a PFIC if at least 75 percent of its gross income is "passive income" (53) or if at least 50 percent of its assets (54) produce passive income or are held for the production of passive income. (55)

If applicable, the PFIC rules generally eliminate deferral by deeming any amount realized by a taxpayer on a sale of PFIC stock (or on receipt of a large distribution from a PFIC) to have been earned proportionately over the period of time the taxpayer held the PFIC stock. Section 1291 of the Code requires the taxpayer to pay interest penalties related to income attributed to prior years as if taxes on such income had been due in such prior years. Alternatively, a shareholder of a PFIC may make a qualified electing fund (QEF) election under subsection 1295(b) of the U.S. Code to include income from a PFIC on an accrual basis under section 1293 (with a potential election in section 1294 of the Code to defer payment of tax on certain undistributed earnings). In addition, section 1296 of the Code contains an elective mark-to-market regime for "marketable stock" (as defined in subsection 1296(e)) in a PFIC, with accrued gains determined at the close of the taxable year included in gross income, and accrued losses allowed only to the extent of prior income inclusions with respect to such stock.

Both the FIE Rules and the PFIC rules are extremely complicated and potentially difficult for investors holding minority interests to comply with. The FIE Rules have the advantage of an annual FIE determination, which allows a FIE to be "cleansed" to prevent FIE status in later years. In contrast, a foreign corporation may be permanently tainted by a finding of PFIC status. In addition, FIE status may not have the devastating status on equity financing that PFIC status has in the United States. In particular, investors may be willing to acquire equity interests in a FIE (as such interests may well be exempt from the FIE Rules, such as under the Open Market Exemption), whereas many investors will not be willing to acquire an interest in a PFIC.

Another potential advantage under the FIE Rules is that a taxpayer subject to that regime can determine its taxes owing in a particular year (i.e., by multiplying its designated cost by the prescribed interest rate), whereas under the PFIC rules the taxpayer is generally forced to wait until a future realization event and pay interest penalties on the taxes deemed to have been owing for prior years.

Both the PFIC regime and the FIE Rules are intended to only tax realized gains. The FIE Rules, however, may result in a prescribed income inclusion each year (even where a FIE operates at a loss), followed by an eventual loss on disposition. Such income in early years followed by a loss on disposition is equivalent to an interest-free loan by the taxpayer to the Canadian government to the extent that the taxes paid are later offset by losses. A new "reconciliation" rule has been added to prevent "over accrual" under the prescribed interest rate regime of the FIE Rules by recharacterizing capital losses on disposition as ordinary losses to the extent of prier FIE income inclusions. (56)

Practical Issues

The potential effect of the FIE Rules may be illustrated through the following examples.

Example 1--Listed Shares

USCO is a corporation resident in the United States for the purposes of the Act and the Canada-U.S. Income Tax Convention. A class of shares of USCO (Listed Shares) is listed on the New York Stock Exchange, and more than 10 percent of the Listed Shares are held by Canco, a Canadian taxpayer.

Potential application of the FIE Rules to the Listed Shares:

1. Ordinarily, a Canadian taxpayer's ownership of the Listed Shares would be expected to qualify for the Open Market Exemption described above. The Open Market Exemption is net available to Canco because Canco owns more than 10 percent of the Listed Shares, but three additional exemptions from the FIE Rules may apply.

First, if Canco owns at least 10 percent of USCO by votes and value then Canco may be able to elect under draft paragraph 94.1(2)(h) to treat USCO as a CFA. Although this election would result in Canco's interest in USCO being subject to the FAPI regime, this may be a favorable result given that the FAPI rules contain less uncertainty and may net result in any income inclusion if USCO does net have any income for the year or its income is considered to be active business income for purposes of the FAPI rules. This election would net be available, however, if Canco does net own the requisite 10-percent votes and value of USCO, (57) and would also net be available if the CCRA makes a demand for information that Canco is unable to comply with.

Second, if Canco is a "financial institution," the Listed Shares may be "mark-to-market property" (58) or market-valued inventory, exempt from the FIE Rules although deferral on any accrued gains would be prevented by existing regimes (59) if this were the case. In general terms, the Listed Shares would net be subject to the existing mark-to-market regime if Canco owns at least 10 percent of the votes and value of USCO. (60)

Third, an exemption from the application of the FIE Rules (other than the tracking interest rule referred to below) would also be available if USCO is net a FIE at the end of the year (such as where its principal undertaking throughout the year is a business that is net an investment business, or less than 50 percent of its property is investment property). It may be difficult to prove, however, that USCO is net a FIE. Also, USCO may be deemed to be a FIE if the CCRA makes a demand for information that Canco is unable to comply with. Canco may be able to establish that USCO is net a FIE, particularly if USCO's assets de net consist primarily of financial assets (such as shares, debt and cash) or if all of USCO's assets are used or held in carrying on a non-investment business.

2. If USCO is net a FIE, there is still a concern with regard to the potential application of the "tracking interest" rules. If the Listed Shares were the sole class of shares of USCO, the "tracking interest" rules (described above) should net apply. In other cases, it would be necessary to examine more thoroughly the nature of the entitlements with regard to each class of shares in order to determine what (if any) property is "tracked property" with regard to the Listed Shares.

Example 2--Exchangeable Shares

Canadian taxpayers (who are hot U.S. citizens) own shares of Cansub, a Canadian corporation controlled by USCO. The Cansub shares are widely held, with no one non-arm's length group holding more than 10 percent of the value. The minimum 150 shareholder/$500 value test is also satisfied. The shares of Cansub are exchangeable into shares issued by USCO from treasury which will become part of the Listed Shares. Cansub shares are net listed on any stock exchange, although (as previously discussed) USCO shares are.

Potential application of the FIE Rules to the exchangeable shares:

1. If USCO is a FIE, then the Cansub shares would be considered to be participating interests in a FIE.

2. If the Cansub shares are net acquired or sold in the open market, the shares will net be an "exempt interest" and thus subject to the FIE Rules (but net subject to the tracked interest rule). If the Cansub shares are se acquired, one would expect the Cansub shares to be exempt from the FIE Rules and the tracked interest rule.

Example 3--Foreign Affiliate that Is a FIE

The FIE Rules are net consistent with the foreign affiliate rules (as illustrated by the following example). USCO is a foreign affiliate of Canco that earns active business income for purposes of the FAPI rules, but is also a FIE. Canco is either unable or unwilling to elect to treat USCO as a CFA. USCO pays dividends to Canco out of "exempt surplus," which would normally net be subject to Canadian income tax under the foreign affiliate regime.

Potential application of the FIE Rules to USCO shares:

1. If the prescribed interest rate regime applies in computing Canco's income, the prescribed interest rate would be applied to the "designated cost" of Canco's shares in USCO. The designated cost would net be reduced te take into account dividends paid by USCO. If the mark-to-market regime were used by Canco, the mark-to-market income inclusion would reflect any dividend payable. Alternatively, if the accrual regime is used, dividends paid by USCO would generally be deductible by Canco to the extent already included in Canco's income (to prevent double taxation). As a consequence, in each case Canco could have income under the FIE Rules that would be subject to Canadian tax.

2. Dividends paid by USCO would be included in computing Cauco's income under section 90, but double taxation would be relieved through an equivalent deduction under paragraph 113(1)(a).61 In addition, it appears to be intended that Canco would be entitled to deduct an amount up to the FIE income inclusions under the prescribed interest rate regimes and the mark-to-market regimes under new subsection 94.4(2).

3. Canco could argue that this treatment under the FIE Rules is inconsistent with Article XXIV (2)(b) of the Convention, which prevents certain double taxation between Canada and the U.S., (62) and the non-discrimination clause in Article XXV(5) of the Convention (63) Unless Canco were willing to challenge the interpretation of the CCRA on this point, Canco could be subject to tax under the FIE Rules even though the business income out of which the profits are paid would have been subject to tax in the U.S., and there would have been U.S. withholding tax paid on the dividends (at a 5-percent or 15percent treaty rate, depending on the circumstances). (64)

4. If Canco's "designated cost" of its participating interest is greater than the fair market value of the interest (which could well be the case, especially where substantial dividends have been paid), it would generally be in Canco's interest to sell the Listed Shares (even if it immediately reacquires them). While Canco would not be entitled to the immediate use of any capital loss generated because of "stop loss" rules under the Act, the advantage of the transaction is that it would drive down Canco's "designated cost" and thus lower the amount required to be reported under the FIE Rules.

Example 4--US LLC

US LLC is a limited liability company that carries on business in the United States and Bermuda. US LLC's board of directors generally meets in Bermuda. Canco owns interests in US LLC that are listed on the New York Stock Exchange.

Potential application of the FIE Rules to interests in US LLC:

1. The Open Market Exemption would not be available to Canco, regardless of whether Canco had a tax avoidance motive in respect of the US LLC interests. Although US LLC was formed in the United States (a country with which Canada has a tax treaty), Canada does not consider an LLC to be resident in the U.S. for purposes of the treaty unless it elects under the check-the-box regulations to be treated like a C-corporation.

2. In addition, US LLC would not be entitled to the exemption based on its interests being traded on the NYSE, as US LLC would also not be considered to be resident in the United States. for purposes of the Act. (Residency under the Act is generally determined by where the board of directors meet and make decisions, which in this case would be Bermuda.)

Conclusions

The FIE Rules present many potential challenges for tax executives, especially due to their expected retroactive application to the beginning of 2003 before the final legislation is passed (which is expected to be passed in 2004).

The FIE Rules will discourage Canadian taxpayers from acquiring equity investments (either directly or indirectly though options or exchangeable/ convertible property) in NREs where there is doubt as to the status of such investments under the FIE Rules or there is insufficient information to determine the potential application of the rules. Accordingly, NREs marketing equity investments to Canadian taxpayers should, to the extent possible, ensure that sufficient information is provided to Canadian taxpayers so that they may determine whether the FIE Rules may apply. (65) For example, disclosure documents could indicate whether the residency and the key requirements of the Open Market Exemption are satisfied such that many Canadian taxpayers could avoid the FIE Rules (even if an NRE may be a FIE as determined at year end). An NRE could also undertake to provide qualifying Canadian taxpayers (essentially those holding at least 10-percent votes and value) sufficient information to allow such taxpayers to elect out of the FIE Rules. (66)

Although tax executives should consider the potential application of the FIE Rules to any direct or indirect equity investment by a Canadian taxpayer in an NRE, particular care should be taken with respect to the tracking interest rules. Although such rules were intended to be anti-avoidance rules (e.g., preventing acquisition of letter stock tracking passive assets), their potential application may inadvertently extend to active joint ventures or other NRE equity investments in which there is no tax policy reason for the rules applying.

(1) The FIE Rules were first announced in the February 1999 federal budget and were subsequently modified by June 22, 2000, draft legislation; a September 7, 2000, press release; August 2, 2001, draft legislation; October 11, 2002, draft legislation; and the October 30, 2003, draft legislation.

(2) S. Thompson & P. Marley, "Canada's Foreign Investment Entity Rules--What Tax Executives Need to Know," 55 The Tax Executive 34 (January-February 2003).

(3) All statutory references are to the Act unless stated otherwise.

(4) Under section 91, a taxpayer resident in Canada must include in computing income its proportionate amount of FAPI earned by a CFA of the taxpayer. FAPI is defined in subsection 95(1) to include certain passive investment income, certain business income deemed to net be active (such as where certain connections to Canada exist), and capital gains arising on the disposition of certain passive assets. Substantial technical changes to the foreign affiliate and FAPI rules are contained in draft legislation released by the Department of Finance on December 20, 2002 (though several revisions are expected before that legislation goes into force).

(5) Section 94.1 requires a taxpayer to include in income a specified amount determined by applying a prescribed interest rate to the "designated cost" of an OIFP. In general terms, the OIFP rules apply only if (i) the OTFP is an interest in a "non-resident entity" (other than a CFA of the taxpayer); (ii) the OIFP derives its value primarily from "portfolio investments" in shares, debt, real estate, and other listed passive assets, and (iii) one of the main reasons for the taxpayer acquiring the OTFP is to significantly reduce Canadian income taxes.

(6) A CFA of a Canadian taxpayer is a foreign affiliate (generally a non-resident corporation if the taxpayer directly or indirectly owns et least 1 percent of any class of its shares, and owns at least 10 percent of any class together with related taxpayers) that is controlled by the taxpayer (either alone or as part of a non-arm's length group), by net more than four other persons resident in Canada, or by the taxpayer in conjunction with net more than four persons resident in Canada. "Control" for this purpose generally requires ownership of shares entitling shareholders to elect more than 50 percent of the directors of a corporation.

(7) Unless indicated otherwise, the terms set off by quotation marks in this part are defined in draft subsection 94.1(1); "tracking interests" and "foreign insurance policies" are described in draft subsections 94.2(9) and (10), respectively.

(8) Draft subsection 94.1(4). The specified return is determined in respect of each month in the taxpayer's taxation year, et the end of which the taxpayer holds the participating interest, as 1/12 of the prescribed interest rate multiplied by the designated cost of the participating interest at the end of the month. The prescribed interest rate is two percentage points higher than the interest rate on 90-day Canadian government treasury bills. The prescribed interest rate for the first quarter of 2004 is 5 percent a year.

(9) The recognition of pre-2003 accrued gains or losses on a participating interest is generally deferred until the disposition of the participating interest. In general, the full amount of the annual gains or losses would be included or deducted, as the case may be, in computing income. In certain other cases, pursuant to draft subsection 94.2(20) and draft paragraph 94.2[4)(b), these gains or losses would be treated as capital gains or capital losses, as the case may be. Only 50 percent of a capital gain or capital loss is recognized in calculating income, and capital losses are only allowed as an offset against capital gains.

(10) For property acquired before 2003, the requisite election can be filed on or before the filing-due date for the taxpayer's taxation year in which the FIE Rules are enacted.

(11) Such a non-arm's length transfer could otherwise have reduced the applicable FIE income based on the transferee's short holding period. In addition, the anti-rollover rules prevent taxpayers from avoiding the prohibition on changing the applicable FIE regime through intra-group transfers. The anti-rollover rules apply to a "specified participating interest," as defined in a draft definition in subsection 248(1).

(12) In the case of options and convertible property, it is technically arguable that the relevant property is limited by a qualification that it must be "under a contract." The Federal Court, however, considered very similar language in Lusita Holdings Limited v. The Queen, 82 DTC 6297, and held that the relevant property was net limited to contractual rights. The Crown's appeal to the Federal Court of Appeal was dismissed at 84 DTC 6346, though this technical argument was net specifically addressed by the Federal Court of Appeal.

(13) In Technical Interpretation 2003-0023435 (November 7, 2003), the Canada Revenue Agency (CRA) confirmed that cash settled derivative contracts will net be "participating interests" under the revised FIE Rules. The CRA had taken a contrary view in respect of the prier version of the FIE Rules in Technical Interpretation 2003-0008355 (April 24, 2003).

(14) A corporation is net resident in Canada for purposes of the Act if it is net incorporated under the laws of Canada (or a province of Canada) and its central management and control is net in Canada. The primary test of residence of a trust under the Act appears to be the residence of the trustees of the trust. See Thibodeau Family Trust v. M.N.R., [1978] DTC 6376 (FCTD) (although there is some authority indicating that where the assets of the trust are managed is an important factor). See W.D. Goodman, "Canadian Trusts with Non-Resident Beneficiaries and Non-Resident Trusts with Canadian Resident Beneficiaries," Report of Proceedings of the Fortieth Tax Conference, 1988 Canadian Tex Foundation Conference 39:1 (1989). In addition, draft subsection 94(3) contains a surprisingly broad rule that applies for the purpose of the NRE definition (and other specified purposes) to deem certain non-resident trusts to be resident in Canada if a person resident in Canada has made a direct or indirect transfer or loan to the trust.

(15) For this purpose, a "registered" pension plan is One registered under the Act. A pension plan may also be registered under federal or provincial pension benefits legislation.

(16) Part I includes the basic charging provisions for income tax. An exempt taxpayer does net include an entity (e.g., a trust or a partnership) in which an exempt taxpayer invests, even if 100 percent of the equity interests in the entity are held by exempt taxpayers and all of its income is flowed-through to exempt taxpayers. Most tax-exempt taxpayers are exempt from the administrative burden of the FIE Rules and are therefore net required to make basis adjustments to their participating interests in FIEs. Such adjustments would otherwise have affected tax-exempt retirement vehicles in determining whether foreign investments exceed their allowable 30-percent foreign property basket (which could result in a penalty tax under Part XI).

(17) Unfortunately, the definition "exempt taxpayer" requires each beneficiary of the Canadian resident trust to hold a "specified fixed interest" in the trust, as defined in draft subsection 94(1). That expression is currently defined se narrowly that it is doubtful that any interest of a beneficiary in a trust would qualify.

(18) An additional exception from FIE statue is provided for most "exempt foreign trusts" as defined in draft subsection 94(1).

(19) Draft paragraph 94.1(2)(q).

(20) Draft paragraph (a) of the definition "exempt property."

(21) Draft paragraph (b) of the definition "exempt property."

(22) Draft paragraph (c) of the definition "exempt property."

(23) Draft subparagraph (n)(i) of the definition "investment property."

(24) Draft subparagraphs (n)(ii) and (iv) of the definition investment property." See note 28 for further detail on the 25-percent interest test. This fifth exclusion is of limited significance since the carrying value of such shares and debt would be expected to be nil in many cases if consolidated accounting principles are used. The carrying value of such shares and debt would also be expected to be nil if an Unconsolidated Election (as defined in the text that follows) is made in conjunction with an election under draft paragraph 94.1(2)(j).

(25) Under the definition "financial statement" and draft paragraph 94.1(2)(b), permissible GAAP is Canadian GAAP, U.S. GAAP, GAAP of a European Union country, and GAAP that is "substantially similar" to Canadian GAAP. It is unclear whether GAAP of any other country would be considered to be "substantially similar" to Canadian GAAP.

(26) The election is provided under paragraph (a) of the draft definition "financial statements." The Explanatory Notes refer to the election being one to use unconsolidated statements, but the text of the legislation is less clear on this point.

(27) Draft paragraph 94.1(2)(a).

(28) The definition "significant interest" requires a particular entity (with related entities) to own at least 25 percent of the fair market value of the interests in the other entity. Where the other entity is a corporation, it is also necessary for the particular entity (with related entities) to have at least 25 percent of the shareholder votes in the other entity.

(29) Draft paragraph 94.1(2)(j).

(30) Draft paragraph 94.1(2)(e). As currently drafted, this rule assists only in determining whether an NRE's "investment business" is its principal business. It does not expressly identify whether a business that is net an investment business is the NRE's "principal undertaking," as is now required in paragraph (c) of the definition "foreign investment entity." This rule win likely be modified to correspond more closely with the language now used in the FIE definition.

(31) For example, where an NRE simply holds shares of a wholly owned subsidiary, the look-through rule may allow FIE status to be avoided.

(32) Draft subparagraphs 94.1(2)(e)(ii) and (iii).

(33) For taxation years beginning after 2002 and before October 30, 2003, an exempt interest includes all participating interests in qualifying entities.

(34) The mark-to-market exemption generally applies to a share of the capital stock of a corporation, where the owner of the share is a financial institution (as defined in subsection 142.2(1)) that (together with non-arm's length persons) has less than a 10-percent interest in the corporation. Where this is the case, the financial institution is required to report accrued gains or losses in respect of such shares on an annual basis irrespective of the FIE Rules.

(35) See note 6 for a description of the definition "foreign affiliate."

(36) Draft paragraph 94.1(2)(h). Under draft paragraph 94.1(2)(i) the CRA can demand information from a Canadian taxpayer related to the CFA election; if the CRA does not receive satisfactory information within 60 days (or a longer period allowed by the CRA), the CFA election is deemed never to have been made.

(37) Although the definition treats a partnership like a corporation, the reference to partnership is of little relevance in the context of this exemption as a "qualifying entity" will be an "exempt interest" only if it is a corporation (more specifically, a foreign affiliate). The requirement for a "qualifying entity" to be a foreign affiliate applies to taxation years beginning on or after October 30, 2003.

(38) Although the CRA generally considers "all or substantially all" to mean 90 percent or more (e.g., Interpretation Bulletin IT-171R2, [paragraph] 12), case law indicates a somewhat lower threshold may be sufficient (e.g., Quantetics Corporation v. M.N.R., 2000 DTC 2177 (TCC), and Douglas Wood v. M.N.R., 87 DTC 312 (TCC)).

(39) See note 28 regarding detail on what constitutes a "significant interest."

(40) Under sections 3200 and 3201 of the Income Tex Regulations, the principal stock exchanges in the following countries are prescribed: Australia, Belgium, Canada, France, Germany, Hong Kong, Italy, Japan, Mexico, Netherlands, New Zealand, Singapore, Spain, Switzerland, United Kingdom, United States, Ireland, Israel, Austria, Denmark, Finland, Norway, South Africa, and Sweden. On June 23, 2003, the Department of Finance (2003-032) indicated that stock exchanges in Luxembourg and Poland would also be prescribed.

(41) Canada has entered into tax treaties with 81 countries. A1though the Department of Finance has not suggested that any particular country will be prescribed by regulation, it is possible that certain low tax treaty countries may ultimately be prescribed.

(42) As a practical matter it may be difficult for an investor holding a minority interest to establish that et all relevant times at least 150 persons hold identical interests with a value of at least Cdn.$500.

(42) A While the wording of the October 30, 2003, draft legislation is somewhat different, there is a recently published letter from the Department of Finance that suports the use of the wording set out.

(43) Draft paragraph (b) of the definition "arm's length interest."

(44) Draft paragraphs 94.1(2)(k) to (n). This tax avoidance motive test is similar to the test in the OIFP rules, except that the OIFF rules refer explicitly to the avoidance of Canadian income taxes. The tax avoidance motive test under the FIE Rules is broader than under the OIFP rules as it could potentially apply to the avoidance of foreign taxes (although it would be expected to apply principally where the NRE is resident in a tax haven).

(45) Draft subsection 94.2(9).

(46) Such property would include property deemed to be owned by the NRE under the consolidation rules. The property, however, would appear not to include property deemed to be owned by the NRE under the look-through rule in draft paragraph 94.1(2)(j).

(47) Although the tracking interest rules would not apply if there is not "tracked property" associated with such shares, the definition of "tracked property" is sufficiently vague that a liquidation entitlement typically associated with a common share could arguably give rise to "tracked property."

(48) For this purpose, the first three exclusions from "investment property" described above do not apply.

(49) See note 48.

(50) Draft legislation released by the Department of Finance on December 20, 2002, also proposes a new paragraph 95(2)(g.3), which does not related to the provisions described in this article. The latter provision will likely be re-numbered before final legislation is enacted.

(51) Various technical issues apply to draft paragraph 95(2)(g.3). For example, the rule does not appear to contemplate interests in an NRE held through a partnership. In addition, the exclusion from FAPI ostensibly only applies to participating interests held throughout a taxation year of a foreign affiliate. Both of these issues have been brought to the attention of the Department of Finance, which appears sympathetic to correcting these anomalies.

(52) A detailed description of the PFIC regime and its complex regulations is beyond the scope of this article.

(53) "Passive income" is defined in subsection 1297(b) of the U.S. Code as income that would be "foreign personal holding company income" in subsection 954(c), subject to certain exceptions (such as for income from certain active banking or insurance businesses, and certain income received or accrued from a related person allocable to non-passive income of such related person).

(54) Subsection 1297(f) of the U.S. Code provides that the asset test is generally determined by value, except that assets of a non-publicly traded corporation that is a controlled foreign corporation or that makes an election may be determined by adjusted basis.

(55) Subsection 1297(c) of the U.S. Code contains a look-through rule for 25-percent owned corporations that is generally analogous to draft 94.1(2)(j) of the FIE Rules. In addition, subsection 1297(e) of the U.S. Code contains an exception foreign the PFIC regime for a United States shareholder of a controlled foreign corporation that is similar to the CFA exception in the FIE Rules.

(56) Draft subsection 94.1(5). "Over accrual" could otherwise have arisen because of ring fencing (if the taxpayer did not have sufficient capital gains to use such losses) and because the Act only permits 50 percent of capital losses to be recognized.

(57) Under paragraph 95(2)(m), a "qualifying interest" in a corporation requires a minimum 10 percent of the voting shares and value of the corporation. (Although draft paragraph 95(2)(n) generally allows "qualifying interest" status to certain other related taxpayers for purposes of the foreign affiliate rules, this relieving rule will apparently not apply for purposes of the FIE Rules, since as those rules refer specifically to paragraph 95(2)(m).) Even if the Listed Shares were the only class of shares, a minority discount might prevent the 10-percent value test from being satisfied. Also, if the Listed Shares are of a class with limited voting rights, the 10-percent votes test may hot be satisfied (as the shares must have full voting rights under all circumstances).

(58) As defined in subsection 142.2.

(59) As to the "mark-to-market" regime, see subsection 142.5(1).

(60) In this case, the 10-percent votes and value test is provided under subsection 142.2(2).

(61) This assumes USCO's income is derived from an "active business" in a treaty country (such as the United States).

(62) Article XXIV(2)(b) of the Convention provides that Canada is to avoid double taxation with the United States by allowing a company resident in Canada to deduct any dividend received by if out of the exempt surplus of a foreign affiliate resident in the United States. Although the treaty allows Canada to modify Canadian law, any modification must hot affect the general principle of effectively exempting such dividends from U.S. foreign affiliates. The FIE regime arguably affects such general principle by requiring a second income inclusion in respect of the U.S. affiliate effectively causing otherwise exempt income to be taxable in Canada. While this second income inclusion is mitigated by the double taxation deduction, it is possible that this deduction is later than the initial related inclusion and may hot be of any much utility (e.g., if the deduction creates a loss which cannot be carried back sufficiently because of the three-year limitation for the carryback of losses).

(63) The non-discrimination clause in Article XXV(5) of the Convention provides that where Canco owns USCO, Canada will hot tax USCO in a manner that is more burdensome than if USCO had been resident in Canada. Although the FIE Rules do not tax USCO directly, the taxation of Canco is potentially more burdensome than the tax that would have arisen had USCO been resident in Canada (particularly if USCO has an operating loss as the FIE Rules could nevertheless require an income inclusion).

(64) Canco would not be entitled to a foreign tax credit with respect to such U.S. withholding tax due to restrictions on tax credits on dividends paid by foreign affiliates. Canco would also not be entitled to a deduction under draft subsection 94.4(3) for the same reason.

(65) The potential application of the FIE Rules would often need to be highlighted in tax disclosure provided to Canadian taxpayers in a prospectus or other offering document in respect of equity investments in NREs.

(66) As discussed at note 36, qualifying Canadian taxpayers may elect to treat an NRE as a CFA which would be subject to the FAPI regime rather than the FIE Rules. The tracking interest rules could still apply despite the making of this election. Also, a Canadian taxpayer that elects to treat an NRE as a CFA may require additional information from the NRE to report appropriate amounts under the FAPI regime that applies as a consequence of making this election.

SIMON THOMPSON AND PATRICK MARLEY are affiliated with the Toronto office of Osler, Hoskin & Harcourt LLP. Mr. Thompson was a senior official in the Tax Legislation Division of the Canadian Department of Finance before joining the firm. The authors think Richard Tremblay of the firm for his invaluable comments on earlier drafts of this article.

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