Canada's foreign investment entity rules: what tax executives need to know

Simon Thompson

On October 11, 2002, the Canadian Department of Finance released a third draft of complex tax legislation on the treatment of direct or indirect investments in foreign entities by Canadian taxpayers (the FIE Rules). (1) This article provides an overview of the FIE Rules and addresses the issues that tax executives should consider in managing risks associated with their application. Complicating this task is the high likelihood that significant technical changes may be made before the FIE Rules are passed into law. It is anticipated that the FIE Rules will be passed into law later this year, and will apply retroactively from January 1, 2003.

I. BACKGROUND

For many years, the Canadian government has attempted to prevent Canadian investors from arranging to earn "passive" income outside Canada to achieve Canadian tax savings. The Canadian Income Tax Act (Canada) (the Act) addresses this concern primarily through two anti-deferral regimes: (2) the foreign accrual property income (FAPI) rules, (3) and the offshore investment fund property (OIFP) (4) rules.

The FIE Rules will replace the OIFP rules and will backstop the FAPI rules (which only prevent deferral in respect of controlled foreign affiliates (CFAs)). (5) Although each of these regimes differ significantly from their equivalent regimes in the United States under the Internal Revenue Code (the Code), the FAPI and FIE/OIFP rules have the same general tax policy objectives as the Subpart F and passive foreign investment company (PFIC) rules, respectively.

II. FIE RULES

The FIE Rules substantially extend the OIFP rules, raising numerous policy and administrative concerns, as highlighted below.

A. Basic Charging Rule

Subject to the application of an anti-avoidance rule for "tracking interests" (discussed below) and "foreign insurance policies," the FIE Rules apply to a Canadian taxpayer holding a "participating interest" in a "non-resident entity" (NRE) where: (6)

* the taxpayer is not an "exempt taxpayer";

* the NRE is a "foreign investment entity" (FIE); and

* the participating interest is not an "exempt interest."

Where these conditions are all met, the Canadian taxpayer must include a specified return in computing income equal to a prescribed interest rate multiplied by the "designated cost" of the participating interest. (7) Subject to certain transitional rules, the "designated cost" will generally be equal to the sum of the participating interest's cost and past amounts included in income under the FIE Rules in respect of the participating interest. If a participating interest has a "readily obtainable fair market value," (8) the Canadian taxpayer may elect that the prescribed rate regime not apply, in which case annual post-2002 accrued gains (and accrued losses) (9) would be recognized on an annual basis. (10) For property acquired after 2002, the mark-to-market election must be made with regard to the first year in which a participating interest is acquired. (11)

The FIE Rules may also result in FAPI to a CFA of a Canadian taxpayer, since 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" represents an equity interest in a corporation, trust, partnership, or other entity. It also includes an option to acquire such an equity interest and property convertible into such an equity interest. 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.

2. Non-Resident Entity (NRE)

An NRE includes a corporation (12) or a trust (13) that is not resident in Canada for purposes of the Act. An NRE also includes a partnership or other organization, generally when they are formed under foreign laws. A FIE, however, does not include a partnership.

3. Exempt Taxpayer

There are two classes of "exempt taxpayers" excluded from the FIE Rules: recent immigrants to Canada (resident in Canada for up to 60 months) and most persons (such as trusts governed by pension plans registered under the Act) expressly exempt from Part I tax. (14)

4. FIE

An NRE is generally considered to be a FIE (15) at a particular time unless either of the following tests is satisfied:

* the carrying value of the NRE's "investment property" is not greater than 50 percent of the carrying value of all its properties (referred to below as the "50-percent investment property test"), or

* the NRE's principal business is not an "investment business."

As a result of the complexity and the form of the FIE Rules and scarcity of information, many Canadian taxpayers (particularly investors holding minority interests) will likely make investments in NREs without knowing (or being in a position to demonstrate, if challenged) whether or not the NRE is a FIE. In addition, avoiding the application of the FIE Rules may be difficult since the Canada Customs and Revenue Agency (the CCRA) is authorized to demand information (in addition to their normal powers of reassessment) from a Canadian taxpayer requiring the taxpayer to demonstrate to the CCRA's satisfaction that an NRE is not a FIE. (16) If the Canadian taxpayer does not provide the requested information within 60 days (or a longer period acceptable to the CCRA), the NRE is deemed to be a FIE. Several other elements of the FIE Rules contain similar administrative overrides that potentially expand the application of the FIE Rules where requested information is not provided in a timely manner to the CCRA.

(a) 50-Percent Investment Property Test

"Investment property" of an NRE generally includes passive assets, such as shares, debt, and real estate. Exclusions (17) from "investment property" include:

* property used or held in a business (other than an investment business, as described below), (18)

* certain debt between affiliated corporations, the income from which would be characterized as active business income for FAPI purposes, (19)

* certain property accumulated for a temporary period (generally up to 36 months) for the purpose of a qualifying active use, (20) and

* shares and debt issued by "qualifying entities" (described below) in which the NRE has a minimum 25-percent interest. (21)

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). (22) A Canadian taxpayer can elect to value property of an NRE at its fair market value, as long as the property is so valued on the NRE's balance sheet.

Consolidated financial statements (23) must be used in determining whether or not the 50-percent investment property test is satisfied, unless the taxpayer elects to use unconsolidated financial statements (the Unconsolidated Election). In either case, the general intent of the FIE Rules is to ignore shares and debt owned by an NRE in its affiliates for purposes of the 50-percent investment property test, and to deem the NRE to own a proportional amount of the affiliates' assets. (24) If consolidated financial statements are used, the NRE's affiliates are considered to be those entities whose assets are reflected in the consolidated statements (25) and the specified proportionality is based on the NRE's proportional interest in the retained earnings (and income) of each affiliate. (26) If the Unconsolidated Election is made, the NRE's affiliates are considered to be those entities linked by minimum 25-percent direct or indirect interests. (27)

Significant problems may arise in applying these constructive ownership or look-through rules. We understand that an NRE's consolidated balance sheet would typically not reflect any proportionate interest in assets of its affiliates. Rather, consolidation would likely result in an NRE effectively being shown as owning 100 percent of the assets of its affiliates, with an entry on the liability side of its consolidated balance sheet reflecting minority interests in its affiliates. While the Unconsolidated Election could be made and the look-through rule in draft paragraph 94.1(2)(j) applied, that rule requires a great deal of information (28) about the assets and activities of entities in which the NRE may only have a minority interest. (29)

In addition, information on financial statements often may not be specific enough to determine whether an asset is "investment property" for the purposes of the FIE Rules. Consequently, except in rare cases, it will be difficult to rely solely upon financial statements for determining whether or not the 50-percent investment property test has been met.

(b) Investment Business Test

As previously noted, an NRE will not be a FIE if its principal business is not an "investment business."

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" (as previously described, except that the first three exclusions do not apply in this case).

An "exempt business" is the business of certain regulated financial institutions, 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 or not an NRE's principal business is an investment business depends on all the facts and circumstances, though the look-through rules used for the 50-percent investment property test apply in a similar manner in connection with determining whether or not an NRE's principal business is an investment business. (30)

5. Exempt Interest

The FIE Rules do not apply to an interest in a FIE that is an "exempt interest." There are several categories of exempt interests in a FIE:

* participating interests in a CFA of a Canadian taxpayer,

* participating interests in a "qualifying entity," certain participating interests that are "widely held and actively traded" that are not acquired with a defined tax avoidance motive (referred to below as the "Widely Held Exemption"),

* participating interests that are "mark-to-market" properties of a financial institution, (31)

* certain participating interests acquired by Canadian taxpayers as employees, and

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

(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. As 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 (32) by electing for that affiliate to be treated as a CFA provided the taxpayer has a minimum 10-percent economic interest in the affiliate. (33)

(b) Qualifying Entity Exemption

A "qualifying entity" is generally a corporation (34) where all or substantially all of the carrying value of its property is attributable to property that is not "investment property" or certain narrow categories of "investment property." (35) 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" described above) 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. (36)

(c) Widely Held Exemption

The Widely Held 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 a FIE if all of the following conditions are satisfied:

(1) either (a) the participating interest is of a class of property listed on a prescribed stock exchange and the FIE is resident for purposes of the Act in a country in which any prescribed stock exchange is situated, (37) or (b) the FIE 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) (38) and, in general terms, is governed by the laws of that treaty country,

(2) 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, (39)

(3) the participating interests are generally available and qualified for distribution to the public under the securities law of the country in which the FIE is governed,

(4) the Canadian taxpayer (with non-arm's length parties) owns no more than 10 percent (40) of the participating interests in the class, (41) and

(5) the participating interest was not acquired with any defined tax avoidance motive.

A taxpayer will be considered to have a tax avoidance motive in respect of the acquisition of a participating interest only if it is reasonable to conclude that one of the main reasons for acquiring the interest was Canadian tax savings or deferral. (42) 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 Code).

C. Tracking Interest Rules

The FIE Rules contain broad anti-avoidance rules (the "tracking interest" rules) that are intended to prevent avoidance of the rules where an investor does not otherwise hold a participating interest in a FIE but 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 complicated and may apply in anomalous situations (particularly as a result of the vague notion of "tracked property," discussed below). (43)

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 taxpayer is not an exempt taxpayer,

* the participating interest does not fall within the Widely Held Exemption, is not mark-to-market property of a financial institution, and is not exempt under the above provision for certain interests held by Canadian taxpayers that are U.S. citizens, (44)

* the taxpayer is entitled in the particular year to receive payments in respect of the participating interest, directly or indirectly, determined primarily with reference to specified criteria (including fair market value and profit) with regard to one or more properties (collectively referred to as the "tracked property" in respect of the participating interest),

* all or substantially all of the fair market value of the tracked property is not qualifying shares of a foreign affiliate of the taxpayer 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.

Where the tracked property is owned by the NRE, (45) the NRE will generally not be a tracking entity in respect of a participating interest if at least 90 percent of the NRE's property is tracked property. Accordingly, the tracking interest rules do not apply to most common shares, as such shares would usually (46) track 100 percent of the NRE's property. (47) Also, the tracking interest rules will generally not apply where at least 50 percent of the NRE's tracked property is 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). (49)

If any part of the tracked property is not owned by the NRE, it appears that the NRE is presumed to be a "tracking entity." (50)

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) of the Act, which deems a foreign affiliate (including a CFA) to be a Canadian taxpayer when applying the FIE Rules for calculating FAPI. (51) 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 exclusion from the FIE Rules is only available for a CFA of the Canadian taxpayer). (52)

Without reference to draft paragraph 95(2)(g.3), it is clear that income from a participating interest in an NRE that is used or held in the course of carrying on an "active business" for the purposes of the FAPI rules would not be included in computing FAPI. Although the effect of draft paragraph 95(2)(g.3) on such income could be clearer, informal discussions with Department of Finance officials suggest that draft paragraph 95(2)(g.3) of the Act was not intended to convert into FAPI what would otherwise have been treated as income from an "active business." While this interpretation appears to be appropriate and clearly the better view as a matter of law, it is hoped that greater clarity will be provided before the FIE Rules are enacted.

III. COMPARISON TO THE U.S. PFIC RULES (53)

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 Code indicates that a foreign corporation is a PFIC if at least 75 percent of its gross income is "passive income," (54) or at least 50 percent of its assets (55) produce passive income or are held for the production of passive income. (56)

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 Code to include income from a PFIC on an accrual basis under section 1293 of the Code (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 section 1296(e) of the Code) 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 will not likely have the devastating status on equity financing that PFIC status has in the U.S. 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 Widely Held 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 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.

The PFIC rules have the advantage of only taxing realized gains, whereas the FIE Rules 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. In addition, "over accrual" can arise under the FIE Rules, as a capital loss on disposition of a FIE interest may be of limited use because of ring fencing (if the taxpayer does not have sufficient capital gains to use such losses) and because the Act only permits 50 percent of capital losses to be recognized.

IV. PRACTICAL ISSUES

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

A. Example 1--Listed Shares

USCO is a corporation resident in the U.S. for the purposes of the Act and the Canada-U.S. Income Tax Convention (the Convention). A class of shares of USCO (the Listed Shares) are 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 Widely Held Exemption. The Widely Held Exemption is not available here, however, because Canco owns more than 10 percent of the Listed Shares. Nevertheless, 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 paragraph 94.1(2)(h) of the Act 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 not result in any income inclusion if USCO does not 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 not be available, however, if Canco does not own the requisite 10-percent votes and value of USCO, (57) and would also not be available if the CCRA makes a demand for information that Canco is unable to comply with.

* If Canco is a "financial institution," the Listed Shares may be "mark-to-market property," (58) exempt from the FIE Rules, though deferral on any accrued gains would be prevented by an existing mark-to-market regime (59) if this were the case. In general terms, the Listed Shares would not 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 not a FIE (such as where its principal business is not an investment business or less than 50 percent of its property is investment property). It may be difficult, however, to prove that USCO is not 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. In addition, the rules for determining FIE status where there are affiliated companies involved are problematic. Nevertheless, Canco may be able to establish that USCO is not a FIE, particularly if USCO's assets do not 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 not a FIE, there is still a potential concern with regard to the potential application of the tracking interest rules (described above). If the Listed Shares were the sole class of shares of USCO, the tracking interest rules should not 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.

B. Example 2--Exchangeable Shares

Canadian taxpayers own shares of Cansub, a Canadian corporation controlled by USCO. The shares of Cansub are exchangeable into shares issued by USCO from treasury which will become part of the Listed Shares.

Potential application of the FIE Rules to the exchangeable shares:

(1) The exchangeable Cansub shares would be regarded as participating interests in USCO.

(2) Draft paragraph 94.l(2)(d) of the Act provides that the FIE Rules apply to an exchangeable share as if the exchange feature had been exercised. Consequently, to the extent that the Widely Held Exemption (or another exemption) applies to USCO's Listed Shares, it should also apply to the Cansub exchangeable shares. (61)

C. Example 3--Foreign Affiliate that is a FIE

USCO is a foreign affiliate of Canco that earns active business income for purposes of the FAPI rules, but that 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 not be subject to Canadian income tax under the foreign affiliate regime.

Potential application of the FIE Rules to USCO shares:

(1) The dividend would be included in computing Canco's income under section 90 of the Act, but double taxation would be relieved through an equivalent deduction under paragraph 113(1)(a) of the Act. (62)

(2) If the prescribed rate regime applied 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 not be reduced to 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. As a consequence, Canco would have additional income under the FIE Rules, which would give rise to a Canadian tax liability.

(3) Canco could argue that this treatment under the FIE Rules is inconsistent with subsection 248(28) of the Act which generally prevents double taxation domestically, (63) Article XXIV(2)(b) of the Convention which prevents certain double taxation between Canada and the United States, (64) or the non-discrimination clause in Article XXV(5) of the Convention. (65) Unless Canco were willing to challenge the interpretation of the CCRA on this point, Canco would 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 15-percent treaty rate, depending on the circumstances). (66)

(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.

(5) This example illustrates the fundamental inconsistency of the FIE Rules with the rules governing the taxation of foreign affiliates.

D. Example 4--US LLC

US LLC is a limited liability company that carries on business in the U.S. 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 Widely Held Exemption would not be available to Canco, regardless of whether Canco had a tax avoidance motive in acquiring the US LLC interests. Although US LLC was formed in the U.S. (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 U.S. 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.)

V. CONCLUSIONS

The FIE Rules present many potential challenges for tax executives, especially because of their expected retroactive application to the beginning of 2003 while their final form is not yet known.

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 or not the FIE Rules apply. (67) For example, disclosure documents could indicate whether or not the residency and widely held/actively traded requirements of the Widely Held Exemption are satisfied such that many Canadian taxpayers could avoid the FIE Rules (even if an NRE is a FIE). 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. (68)

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, and the most recent October 11, 2002, draft legislation.

(2) Another anti-deferral regime in section 17 of the Act may apply to impute interest income to a Canadian taxpayer in respect of certain loans made directly or indirectly by the taxpayer to a non-resident person. In addition, section 245 of the Act contains a general anti-avoidance rule that could apply to prevent deferral in situations where there is a misuse of the provisions of the Act or an abuse of the Act as a whole.

(3) Under section 91 of the Act, a taxpayer resident in Canada must include in computing income its proportionate amount of FAPI earned by a controlled foreign affiliate of the taxpayer. FAPI is defined in subsection 95(1) of the Act to include certain passive investment income, certain business income deemed to not be active (such as where certain connections to Canada exist), and capital gains arising on the disposition of certain passive assets. FAPI is also relevant for foreign affiliates (including CFAs) in determining the extent to which dividends may be repatriated free of Canadian tax to corporations resident in Canada. (Section 113 of the Act provides that FAPI may be sheltered by a grossed-up deduction for certain foreign taxes paid. A more favourable regime is provided for certain active business income that is effectively exempt from Canadian tax (regardless of the amount of foreign taxes paid). 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; this draft legislation does not affect the analysis in this article.

(4) Section 94.1 of the Act requires a taxpayer to include in income a specified amount determined by applying a prescribed rate of interest to the "designated cost" of an OIFP. In general terms, the OIFP rules apply only if:

* the OIFP is an interest in a "non-resident entity" (other than a CFA of the taxpayer),

* the OIFP derives its value primarily from "portfolio investments" in shares, debt, real estate and other listed passive assets, and

* one of the main reasons for the taxpayer acquiring the OIFP is to significantly reduce Canadian income taxes.

(5) A CFA of a Canadian taxpayer is a foreign affiliate (generally a non-resident corporation if the taxpayer directly or indirectly owns at least I 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 not more than four other persons resident in Canada, or by the taxpayer in conjunction with not 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. Under existing paragraph 94(1)(d) of the Act, a Canadian taxpayer's beneficial interest in a foreign non-discretionary trust can also be deemed to represent shares of a CFA if the taxpayer owns 10 percent or more of the total beneficial interests in the trust.

(6) Unless indicated otherwise, the expressions with quotation marks are defined in draft subsection 94.1(1) of the Act. "Tracking interests" and "foreign insurance policies" are described in draft subsections 94.2(9) and (10), respectively.

(7) Draft subsection 94.1(4) of the Act. The prescribed interest rate is to be two percentage points higher than the interest rate on 90-day Canadian government treasury bills. The recent third draft of the FIE Rules differs from the prior two drafts in that there is no longer a proposed election to include income under an accrual method, and the mark-to-market regime that formed the primary charging rule under the prior drafts has been generally relegated to a more limited back-stop role.

(8) Defined in draft subsection 94.2(2) of the Act.

(9) The recognition of pre-2003 accrued gains or losses on a participating interest is generally deferred until the disposition of the participating interest.

(10) 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(21), 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. A capital loss resulting from the application of draft subsection 94.2(21) would only be allowed as an offset against capital gains.

(11) For property acquired before 2003 it should be possible to file the required election with the taxpayer's return for the taxpayer's first taxation year beginning after 2002.

(12) A corporation is not resident in Canada for purposes of the Act if it is not incorporated under the laws of Canada (or a province of Canada) and its central management and control is not in Canada.

(13) The primary test of residence of a trust under the Act appears to be the residence of the trustees of the trust: Thibodeau Family Trust v. M.N.R., [1978] DTC 6376 (FCTD). There is also authority indicating 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" (Chapter 39), Report of Proceedings of the Fortieth Conference, (Canadian Tax Foundation 1989). In addition, draft subsection 94(3) of the Act 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 investment in the trust.

(14) Part I of the Act includes the basic charging provisions for income tax. An exempt taxpayer does not 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 its income is flowed-through to exempt taxpayers. Most tax-exempt taxpayers are exempt from the administrative burden of the FIE Rules and therefore not 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 of the Act).

(15) There are additional exceptions from FIE status for partnerships and specified trusts.

(16) Draft paragraph 94.1(2)(q) of the Act.

(17) Although under a literal reading of the FIE Rules it is not clear that the first three exclusions are meant to be of an overriding nature, informal discussions with Department of Finance officials suggest that this was Finance's intent.

(18) Draft paragraph (a) of "exempt property" in subsection 94.1(1) of the Act.

(19) Draft paragraph (b) of "exempt property" in subsection 94.1(1) of the Act.

(20) Draft paragraph (c) of "exempt property" in subsection 94.1(1) of the Act.

(21) Draft paragraphs (a) and (e) of "investment property" in subsection 94.1(1) of the Act. See note 27 for further detail on the 25-percent interest test. This fourth exclusion is of limited significance since the carrying value of such shares and debt is intended to be nil if an Unconsolidated Election is made and would also, in many cases, be expected to be nil if consolidated accounting principles are used.

(22) Under draft paragraph 94.1(2)(c) of the Act, 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, although a broad interpretation of the expression "substantially similar" is invited since Canadian GAAP is considered for greater certainty to be substantially similar to U.S. and European Union GAAP.

(23) Prepared for an NRE in accordance with permissible GAAP.

(24) Draft paragraphs 94.1(2)(a) and (j) of the Act.

(25) In general, consolidation of an entity with another entity under permissible GAAP requires the first entity to have a controlling interest in the other entity.

(26) Draft subparagraph 94.1(2)(a)(ii) of the Act.

(27) The definition "significant interest" in draft subsection 94.1(1) of the Act provides that the 25-percent test is satisfied if a particular entity (with related entities) owns at least 25 percent of the fair market value of 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.

(28) For example, to apply the look-through rules, the financial information for each affiliate is needed precisely as of the end of the taxation year of the NRE.

(29) Pursuant to draft paragraph 94.1(2)(j) of the Act, if an NRE has a 25-percent investment in another entity and the other entity has a 25-percent investment in a third entity, the third entity would be considered to be an affiliate of the NRE for this purpose even though the NRE's economic interest in the third entity would be only 6.25 percent.

(30) For example, where an NRE simply holds shares of a wholly owned subsidiary, it would only be through the operation of the statutory look-through rules that FIE status for the NRE might be avoided.

(31) This 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) of the Act) 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.

(32) See note 5 for detail on the definition "foreign affiliate."

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

(34) Although the definition treats a partnership like a corporation, the reference to partnership is of little relevance since a partnership is generally excluded from being a FIE.

(35) Although the CCRA generally considers "all or substantially all" to mean 90 percent or more (e.g., Interpretation Bulletin IT-171R2 at para. 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)).

(36) See note 27 for further detail on what constitutes a "significant interest."

(37) Under section 3201 of the Income Tax Regulations, the principal stock exchanges in the following countries are prescribed: Australia, Belgium, 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.

(38) Canada has entered into tax treaties with 79 countries. Although the Department of Finance has not suggested that any particular country will be prescribed by regulation, it is possible that certain low tax countries such as Barbados may ultimately be prescribed.

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

(40) There is an anomaly in the FIE Rules as the 10-percent test is ostensibly applied without reference to participating interests owned by individuals. The Department of Finance is aware of this anomaly and it is expected that it will be corrected before the FIE Rules are passed into law.

(41) Draft paragraphs (e) of "exempt interest" in subsections 94.1(1) and 94.1(2)(f) of the Act.

(42) This tax avoidance motive test is similar to the test in the OIFP rules, and would generally be expected to apply only where the NRE is resident in a tax haven.

(43) The tracking interest rules in prior drafts were significantly amended by the recent third draft of the FIE Rules. Despite these technical changes, the tracking interest rules are highly problematic and further technical changes are almost inevitable.

(44) As currently drafted, this exclusion would apply only in respect of an NRE that is a FIE. As the tracking interest rule may apply to non-FIEs, it is expected that the final version of the FIE Rules will clarify that this exclusion should apply regardless of whether the NRE is a FIE.

(45) Tracked property may include property the NRE is deemed to own under the look-through rules described earlier.

(46) It might not be possible to satisfy the 90-percent test if the NRE's tracked property does not include property deemed to be owned by the NRE as a consequence of the look-through rules described in the text.

(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 in the text do not apply.

(49) If the Unconsolidated Election is made and the tracked property is actually owned by the NRE, however, the 90-percent or 50-percent test must also be satisfied without reference to the look-through rules and without deeming shares and debt owned by an NRE in its affiliates to have a nil carrying value. Property deemed to be owned under the look-through rules described earlier is not considered to be actually owned for this purpose.

(50) Draft paragraph (c) of "tracking entity" in subsection 94.2(1). To escape classification as a "tracking entity" in this case, the taxpayer must establish that it is not reasonable to conclude that any investment property owned by the NRE (or substituted property) could be used to satisfy the entitlement related to the tracked property. This would likely be difficult to satisfy in many cases.

(51) Draft legislation released by the Department of Finance on December 20, 2002, also proposes a new paragraph 95(2)(g.3), which provision has nothing to do with the provisions described in this article. It is anticipated that one of these new provisions will be re-numbered before final legislation is enacted.

(52) There are a number of gaps in draft paragraph 95(2)(g.3). For example, it is unlikely that a foreign affiliate could ever have a tax avoidance motive for the purposes of the Widely Held Exemption with regard to acquiring property since a foreign affiliate would ordinarily not be subject to Canadian tax. Rather, only certain Canadian taxpayers investing in a foreign affiliate would be subject to Canadian tax.

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

(54) "Passive income" is defined in subsection 1297(b) of the 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).

(55) Subsection 1297(f) of the Code provides that asset values are 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 their adjusted bases.

(56) Subsection 1297(c) of the 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 Code contains an exception from the PFIC regime for a United States shareholder of a controlled foreign corporation that is similar to the controlled foreign affiliate exception in the FIE Rules.

(57) Under paragraph 95(2)(m) of the Act a "qualifying interest" in a corporation requires a minimum 10-percent share of the votes and value of the corporation. 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 not be satisfied (as the shares must have full voting rights under all circumstances).

(58) Defined in subsection 142.2 of the Act.

(59) See subsection 142.5(1) of the Act.

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

(61) The operation of draft paragraph 94.1(2)(d) of the Act may potentially have a beneficial impact of notionally diluting the ownership of the Listed Shares, possibly permitting the application of the 10-percent shareholder restriction to be avoided by Canco.

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

(63) Subsection 248(28) provides that provisions of the Act should not be construed to require an income inclusion to the extent that the amount has already been directly or indirectly included. In this case Canco arguably has two income inclusions in respect of its foreign affiliate shares (the dividend and the FIE inclusion).

(64) 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 it 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 not 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.

(65) The non-discrimination clause in Article XXV(5) of the Convention provides that where Canco owns USCO, Canada will not 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 would nevertheless require a prescribed income inclusion).

(66) Canco would not be entitled to a foreign tax credit with respect to such U.S. withholding tax owing to restrictions on tax credits on dividends paid by foreign affiliates.

(67) 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.

(68) As discussed in note 33, 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 joinlng the firm. Mr. Marley is currently completing a Masters in U.S. tax law at New York University. The authors thank Richard Tremblay of the firm for his invaluable comments on earlier drafts of this article.

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