Outward Investment from Canada - The Offshore Perspective
Contributed by Caroline Maxwell
16 January, 2012
For individual Canadian citizens, and those resident in the country for tax purposes, there is really no way to permanently (and legally) shelter foreign investment and business income from Canadian income tax. International Business Companies (IBCs) seem to offer a viable alternative, and may even prove effective in sheltering assets from Canadian tax. However, the CCRA requires that there must be some 'bona fide purpose' other than merely tax avoidance for the establishment of an IBC, so their legality for individuals in a Canadian context is usually questionable, and you are sure to reap the whirlwind if caught out by the CCRA. Immigrant and emigrant trusts, where properly structured, provide partial and temporary protection for foreign assets, and becoming non-resident in Canada is always an option, but other than that, there are no real solutions for individuals.
There are, however, effective and legal ways in which Canadian corporations can utilise offshore affiliates in order to maximise the efficiency of Canadian exempt surplus rules and minimise exposure to FAPI legislation, and it is to these that we now turn. (For the purposes of explanation, a non-resident corporation is considered to be a foreign affiliate if the Canadian corporation or related persons directly or indirectly own at least 10% of any class of shares in that non-resident corporation.)
FAPI stands for Foreign Accrual Property Income, and rules determining what falls into this category (and is therefore liable for Canadian income tax) have been significantly extended and strengthened in recent years. FAPI now includes a foreign affiliate's income for the year from property and business, with the exception of income from 'active business'. On the other hand, Exempt Surplus rules mean that dividends derived from active business profits earned by an affiliate in a country with which Canada has a double tax treaty are generally received tax free in Canada. In order to establish a truly tax efficient corporate structure, then, it is necessary to ensure that as much of the Canadian corporation's foreign income as possible is derived from active business (and therefore qualifies as exempt surplus income, as opposed to Foreign Accrual Property Income).
As previously stated, this is probably best achieved by the establishment of a subsidiary corporation in an offshore jurisdiction, for reasons which will be explained later. However, as the exempt surplus rules specify, the affiliate must be in a jurisdiction with which Canada has a double taxation treaty. Although overall, Canada has over 90 (2010) such treaties, with several more under negotiation, only a few of these are with offshore jurisdictions. Of these jurisdictions, for the specific purpose of establishing an active subsidiary, only Barbados and (to a lesser extent now) Cyprus are really suitable in terms of infrastructure, legislation and corporate taxation regimes.
NB: New legislation which came into force in 2003 set out new rules applying to Foreign Investment Entities (FIE), and applied to holdings by Canadian residents in foreign entities (widely defined) if the principal business of the non-resident entity is an "investment business", which specifically includes a business carried on by the non-resident entity (alone or through a partnership) if the principal purpose of the business is to earn rental income from real estate or profits from real estate sales.
Generally, the rules are designed to accelerate a tax liability on income from the FIE in the hands of Canadian taxpayers under one of two income imputation methods each year, beginning in 2003, which could be well in advance of when income is actually received. There are complex exceptions from the new rules, which advisers say are difficult to apply in practice, and Canadian residents with possible FIE involvement are strongly advised to take professional advice on their position.
A FIE can be any non-resident corporation or trust, or any other entity that is formed and governed outside of Canada, such as an association, fund, organization, joint venture, or syndicate. Interests that could potentially be affected by these new rules include, among others, investments in foreign mutual funds, public and private corporations, call options and certain convertible securities.
Exceptions from the FIE rules include foreign public company shares or mutual fund units that are traded on a US, UK, or certain other foreign stock exchanges or an interest in a US real estate investment trust (REIT) or regulated investment company (RIC). Foreign companies already caught by CFC (Controlled Foreign Corporation) rules are also excluded. There is also a limited exception for a 'widely held and actively traded' holding in a country with which Canada has a double tax treaty, but even then the holding must not have been acquired for tax avoidance purposes.
The FIE rules apply to most Canadian taxpayers, including individuals, corporations, trusts and partnerships. Individuals who have been resident in Canada for less than five years and certain non-profit entities are exempt.
In his March 2007 budget, Finance Minister Jim Flaherty announced that that he would eliminate the deductibility of interest on debt taken on by companies to finance foreign affiliates to stop companies claiming deductions both in Canada and the country where they are making acquisitions.
However, the proposal provoked an outcry from businesses and tax experts, who warned that the move could severely hamper Canadian firms' ability to compete in both the international and domestic market place.
As a result of this outcry, Mr Flaherty was obliged to clarify his proposal, insisting that the plan was aimed only at firms exploiting offshore structures to 'double dip.'
"If one looks at what I've said, every time I've spoken on this topic, I've said the focus and target is on double-dipping, that is double interest deductions by corporations using tax havens," Flaherty told reporters.
He also added that: "We are going to make illegal the use of double deductions and tax havens. They will have the benefit of a single deduction."
"It's about tax fairness. This is a continuing issue in Canada that if we're going to lower taxes overall for individuals and for corporations then we must have tax fairness - that is everybody must pay their fair share and you don't pay your fair share if you're using a tax haven and taking a double dip."
N.B. In December 2008, the Advisory Panel on Canadas System of International Taxation made the following recommendations with regards the taxation of outbound foreign direct investment from Canada:
- Broaden the existing exemption system to cover all foreign active business income earned by foreign affiliates.
- Pursue tax information exchange agreements (TIEAs) on a government-to-government basis without resort to accrual taxation for foreign active business income if a TIEA is not obtained.
- Extend the exemption system to capital gains and losses realized on the disposition of shares of a foreign affiliate where the shares derive all or substantially all of their value from active business assets.
- Review the foreign affiliate definition, taking into account the Panels other recommendations on outbound taxation, the approaches of other countries, and the impact of any changes on existing investments.
- In light of the Panels recommendations on outbound taxation, review and undertake consultation on how to reduce overlap and complexity in the anti-deferral regimes while ensuring all foreign passive income is taxed in Canada on a current basis.
- Review the scope of the base erosion and investment business rules to ensure they are properly targeted and do not impede bona fide business transactions and the competitiveness of Canadian businesses.
- Impose no additional rules to restrict the deductibility of interest expense of Canadian companies where the borrowed funds are used to invest in foreign affiliates and section 18.2 of the Income Tax Act should be repealed.
In response to the panel's report, Finance Minister Jim Flaherty announced the following in the 2009 budget in January:
- Interest Deductibility: Section 18.2 of the Income Tax Act, scheduled to come into force in 2012, constrains the deductibility of interest in certain situations where a Canadian corporation uses borrowed funds to finance a foreign affiliate and a second deduction for that interest is available in the foreign jurisdiction. Early action is being taken in relation to the Panels recommendation concerning section 18.2 because of the conclusions of the Panel on the potential effects of the provision on foreign investment by Canadian multinational firms, particularly in the context of the current global financial environment. Accordingly, it is proposed that section 18.2 be repealed.
- Non-Resident Trusts and Foreign Investment Entities: Outstanding proposals for non-resident trusts and foreign investment entities, first introduced in the 1999 Budget, apply in respect of arrangements under which Canadian residents seek to avoid Canadian tax through the use of foreign intermediaries under circumstances designed to circumvent the application of existing anti-avoidance rules. The government has received submissions, including the Panels recommendations, on these proposals; the government supports the fundamental policy objective of ensuring that Canadian taxpayers should not be able to avoid paying their fair share of income tax through the use of foreign intermediaries, but will review the existing proposals in light of these submissions before proceeding with measures in this area.
- 2004 Foreign Affiliate Proposals: The government will consider the Panels recommendations relating to foreign affiliates before proceeding with the remaining foreign affiliate measures announced in February 2004, as modified to take into account consultations and deliberations since their release.
The government is studying the other recommendations in the international tax reform panel's report.
The strong historical links between Barbados and Canada, coupled with the existence of a double taxation treaty, and a favourable corporate taxation regime for international companies mean that the island has a specific appeal for Canadian corporations wishing to improve their tax efficiency.
For Canadian companies carrying out international trade, commerce, or manufacturing business, and wishing to incorporate offshore, an International Business Company (IBC) is usually the way to go (as long as exports or services provided are to those outside the CARICOM area). In order to qualify for an IBC license, the Canadian company must establish a corporation in Barbados which fulfils the following criteria:
- The subsidiary company should be resident in Barbados, but;
- Not more than 10% of the assets should accrue to residents of the CARICOM area on liquidation, and;
- No more than 10% of dividends or interest income should be remitted to residents of the CARICOM area.
IBC licenses are issued by the Minster of Finance and are renewable annually for a fee of BDS$250. However, setting up an IBC in order to achieve Canadian tax efficiency is far from cheap. In order to satisfy the CCRA that the operation is not a sham, the 'central mind and management' must be located in Barbados, and the IBC must be a full scale company, with working offices, staff, international telecommunications facilities, bank accounts, a board of directors, and a local attorney. Otherwise, for the purposes of Canadian taxation, it will simply be 'looked through'.
Once a Canadian corporation has established an International Business Company in Barbados to act as its offshore subsidiary, it can then start to take advantage of the exempt surplus regime. Here is an example of one way in which this could take place:
- Canacom, a Canadian manufacturing company exporting products around the world establishes an offshore subsidiary, Barbacom, to handle its foreign sales and international marketing. Barbacom charges a 15% mark-up on the value of the goods it sells, or about $850,000 at current export levels. Because corporate taxation for international corporations is only 2.5% in Barbados, as opposed to the Canadian rate of (45% at the time of writing, but since reduced to a headline rate of 19%), the local corporate income tax only comes to a maximum of $21,250 (local expenses would in fact be deducted from the $850,000). The remaining $828,750 (after expenses) can be classified as income from an 'active business', and is therefore not usually subject to FAPI rules, and can be remitted back to the Canadian parent company as a dividend from exempt surplus income under the Canadian foreign affiliate rules.
Obviously circumstances will vary according to the nature and size of the business being conducted by the Canadian parent company and its offshore subsidiary, and expert advice is needed before even considering a move of this kind, but as long as the offshore affiliate is located in a jurisdiction which has a double taxation agreement with Canada, and is conducting 'active business', tax savings of this kind should be possible.
The Barbados treaty was extensively revised in 2002. A key article of the amended agreement is an improvement to information exchange provisions. The Canadian Revenue Agency is also seeking to crack down on a number of tax evasion schemes designed to exploit loopholes in the original treaty, so another important change was the inclusion of provisions for Canada to tax capital gains when assets are clearly shifted from one country to another solely for the purposes of capital gains tax avoidance.
(N.B. The corporate tax rules in Barbados are currently undergoing some transformation as the country 'merges' its onshore and offshore sectors to satisfy the demands of the OECD).
Until recently, Cyprus was a very attractive jurisdiction for Canadian businesses wishing to take advantage of low corporate taxation and Canada's foreign affiliate taxation rules. However, commitments made to the EU and the OECD have begun to nibble away at Cyprus's corporate tax advantage. Cyprus was among the jurisdictions which pledged to amend its tax regime in return for exclusion from the OECD 'blacklist' in June of 2000, and although the island promised that its company and trust management regime would remain the same, Cyprus installed a new 'harmonised' tax regime in 2003 under which a uniform corporation tax rate of 10% applies to all types of company.
Prior to the 2003 changes, IBCs paid just 4.5% in corporate income tax, compared with 20-25% for onshore companies.
Cyprus may therefore remain a good jurisdiction in which to hold subsidiaries in Eastern Europe and some other emerging markets (Cyprus has good tax treaties with most such countries) and is of course now part of the EU, but in general it may lose some of its attraction compared to Barbados.
Until 2003, IBCs in Cyprus were duly authorised offshore limited liability companies, and the following conditions were imposed on foreign corporations wishing to establish one as its offshore subsidiary:
- The entity must be entirely foreign owned
- The objects of the business and source of income must be outside Cyprus
- No local borrowing is permitted
In addition to these requirements, audited annual accounts must be filed with the Central Bank, and all business enterprises are required to register with the Registrar of Companies.
However, as from 1st January, 2003, an offshore company (IBC) no longer has a separate taxation status, and is taxed according to the same principles as a regular company. In addition, IBCs are allowed to trade inside Cyprus. However, an existing IBC which made an irrevocable commitment not to trade inside Cyprus until 2006 could claim the existing low tax rate for the three years 2003, 2004 and 2005.
Other offshore jurisdictions favoured by Canadians (such as the Cayman Islands, the Turks and Caicos Islands, the Netherlands Antilles, and the Channel Islands) will continue to have their uses, but Barbados and Cyprus will probably remain the two most frequently used jurisdictions.
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