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The strengthened Canadian dollar, low interest rates, access to capital, and more realistic pricing has made it more attractive for Canadian businesses to expand to the U.S. In addition to the normal commercial considerations regarding the purchase of a business, there are Canadian and U.S. tax considerations. This article will focus on how to structure the transactions.
For purposes of the article, it is assumed that a Canadian controlled corporation wishes to make a strategic acquisition in the U.S. Although real estate may be owned, the U.S. business is not a real estate business. The target business is an active business for Canadian tax purposes.
Acquisition of U.S. Business
A Canadian corporation may expand in the U.S. by acquiring an existing U.S. business. The issues include whether to structure the acquisition as a share purchase or an asset purchase. The objective would be to reduce Canadian and U.S. taxes on operating the business and the subsequent sale of the business. If the value of the business is not derived primarily from real estate, the subsequent sale of shares of a U.S. company would not be taxable in the U.S.
In the case of a share purchase of a subsidiary in a U.S. consolidated group, the purchaser and the vendor may enter into an election under IRC section 338(h)(10) to step up the basis of the assets in the U.S. subsidiary for U.S. tax purposes. There would be no step-up in basis for Canadian tax purposes. The bump in the cost base of the assets on election may permit losses carried forward to be offset by the gain arising on the asset basis step-up. The vendor would bear the tax. The U.S. company would have a step-up in the tax cost of the assets for U.S. tax purposes.
The U.S. vendor may wish to defer tax on the sale. For example, if real property is sold, a vendor may defer U.S. tax by taking advantage of a like-kind exchange on a sale of real property (that is, an asset sale) and by acquiring a larger property. Alternatively, the U.S. has installment sale rules that may make it attractive for the vendor to have a balance of sale. If the U.S. corporation being acquired has losses, the U.S. imposes limits on loss utilization if more than 50 percent of the shares are acquired, regardless of whether the same business continues to be carried on. The losses of the U.S. company would not be available against the Canadian profits of a Canadian corporate purchaser.
A Canadian corporate purchaser should consider the advantages of forming a U.S. or offshore holding company to acquire shares for the U.S. subsidiary or of forming a U.S. corporation to acquire assets. Care must be exercised in structuring the U.S. entity to avoid U.S. thin capitalization and earnings stripping rules. Creative financing techniques may be available and are outlined below.
A U.S. acquisition company may be used to purchase assets or shares, and it would facilitate consolidated reporting if other U.S. subsidiaries are to be formed in the future. It may also allow the sale of shares of a U.S. operating company owned by a non-Canadian company to be treated as a sale of excluded property for Canadian tax purposes.
The purchase price may be paid in cash or in stock. If a Canadian company is issuing shares to a U.S. vendor, the U.S. vendor would want to structure the transaction to take advantage of a tax-deferred transfer for U.S. tax purposes.
A U.S. tax-deferred transfer may be available for a U.S. vendor that enters into a share-for-share exchange with a Canadian company. The Canadian company must have a value in excess of the U.S. target company and have an operating history. The tax-deferred transfer may take place under IRC sections 367 and 368.
As indicated above, another factor in structuring the transaction is whether the business to be carried on will be an active business for Canadian tax purposes. If the income is likely to give rise to foreign accrual property income in Canada, it may not be advantageous to have a U.S. subsidiary, and the taxpayer should consider having a Canadian corporation acquire the assets. Note that double tax may arise if a U.S. limited liability company is the vehicle to hold assets that produce income that would be treated as FAPI.
Share Sale vs. Asset Sale
There are many factors that should be considered in determining whether to purchase shares or assets of a U.S. corporation.
If the target is a public company, it may be easier to acquire assets than shares to avoid having to make a takeover bid to acquire all the shares of the target.
The tax cost of the shares to the vendor and availability of the long-term capital gains rate to each individual vendor and the tax cost of the assets of the target may affect the pricing for the shares versus assets. An understanding of the tax consequences to the vendor of shares versus an asset sale by the U.S. entity will be relevant. A sale of assets of a C corporation, the shareholders of which are individuals, may result in double taxation (50 percent versus 20 percent federal and state tax if all individuals were to sell the shares when it qualifies as a long-term capital sale).
If an S corporation is the target, an asset sale followed by a liquidation of the S corporation would result in a single level of tax at the shareholder level. Because an S corporation may maintain its U.S. tax status only if purchased by U.S. individuals, an asset sale would be the logical alternative.
A purchaser may prefer an asset sale as a step-up in the tax cost and a tax effective allocation of the purchase price between the assets purchased may be facilitated. However, a share purchase may be easier since no allocation is required. Representations and warranties and a holdback are required as to tax filings and all liabilities (actual and possible litigation, product liability, current and past tax liabilities, environmental liabilities, wrongful dismissal, severance issues, and contingent liabilities) that are not disclosed.
A share purchase will not result in a step-up of the tax cost of the assets, including goodwill, unless an IRC section 338 election is made. An IRC section 338(h)(10) election treats the sale of shares of a U.S. company as an asset purchase.
The target company may have net operating losses that may be accessed by the purchaser on a purchase of shares of the target. NOLs can be carried forward 20 years. The use of the losses is restricted under IRC section 382 on an acquisition of control.
The target may have licenses and leases that are more easily acquired through a share purchase. A share purchase may be attractive if it avoids land transfer taxes or sales tax.
If not all assets of the target are to be sold or are not desired by the purchaser, an asset sale would be the simplest transaction. Alternatively, the purchaser may plan on purchasing the shares or all of the assets, then selling assets that aren't required. A purchase of assets would allow a more favorable price allocation to the assets to be flipped.
If a business is being purchased out of bankruptcy, the assets would be acquired.
If the vendor is to receive shares of the purchaser, a share sale may be appropriate. A tax-deferred transfer or reorganization or an up real estate investment trust structure (exchangeable shares) may be required to enable the U.S. vendor to defer tax.
If an LLC is the target, a Canadian purchaser would prefer an asset purchase or would have to either convert the LLC to a C corporation or use a C corporation to purchase the LLC. Article IV(7)(a) of the Canada-U.S. tax treaty will apply to deny treaty benefits when a Canadian company operates a U.S. business through an LLC. If the LLC is a disregarded entity for U.S. tax purposes, the U.S. will consider it a branch of the Canadian corporation. No treaty relief will be available under Article X of the treaty for U.S. business income earned by the LLC, and it will be subject to 30 percent U.S. branch tax.
Taxation of a U.S. Branch
A Canadian corporation that directly acquires the assets of a U.S. business or operates through a U.S. partnership would be viewed as operating a branch. A Canadian corporation with a U.S. branch would be taxable in both the U.S. and Canada, assuming the company is not a manufacturer. There would be no provincial tax if the business is not carried on in Canada. For Canadian tax purposes, profits of the U.S. branch would be computed in accordance with generally accepted Canadian accounting principles rather than U.S. accounting principles. Any start-up losses of the U.S. branch would be fully deductible against Canadian profits.
To the extent U.S. corporate taxes and branch taxes apply, a foreign tax credit would be available in Canada under subsection 126(2) of the Income Tax Act. To the extent there would be any nonbusiness income for Canadian tax purposes, a foreign tax credit would be available under section 126(1), and the excess taxes that are not eligible for a credit in Canada would be deductible under subsection 20(12).
In the U.S., there may be a U.S. tax on excess interest (referred to as branch-level interest tax). The tax is not eligible for a credit, although it may be deductible.
When a Canadian taxpayer incurs a business loss from a foreign branch in a tax year, the amount of Canadian tax otherwise payable on foreign-source income may be reduced. That may occur whenever the loss reduces the taxpayer's total income to an amount less than the foreign-source income.
The Canadian tax payable may be less than the foreign tax paid on the income, which would limit the foreign tax credit that could be claimed. If the Canadian tax rate is the same or greater than the foreign tax rate but the Canadian tax payable is less because the taxpayer has losses from other sources, section 110.5 of the ITA permits a Canadian corporation in those circumstances to increase its taxable income to claim an additional foreign tax credit. The amount added to taxable income is added to the corporation's noncapital loss for the year to be carried over to subsequent tax years.
Income will be computed for U.S. tax purposes under U.S. rules, which may result in a different amount of income because of the differences in the two countries' tax systems. For example, in the U.S., depreciation is claimed based on statutory useful lives, while in Canada, the capital cost allowance is arbitrarily determined. There may be differences on when interest must be capitalized or may be deductible. Fees that are accrued and payable to a related non-U.S. party are deducted only when paid in the U.S., while an accrual deduction may be possible in Canada. Goodwill may be amortized over 15 years in the U.S. on a straight line basis, while in Canada, only three-fourths of an eligible capital expenditure may be amortized at the rate of 7 percent per annum on a declining balance basis.
Canada's transfer pricing rules, under section 247 of the ITA, envision a two-party transaction. But when a Canadian corporation operates a U.S. branch, there is technically only one entity. Information Circular IC-87-2R, however, indicates that the transfer pricing principles that apply to two-party situations should provide general guidance for dealings with a foreign branch. The administrative practice of the Canada Revenue Agency requires an arm's-length sales price be applied to a branch. The treaty contemplates transfer pricing being applicable to a branch. The U.S. takes a different approach, generally disregarding transactions between a Canadian corporation and its U.S. branch and determining the income and expenses of the Canadian corporation that are allocable to the U.S. branch.
There are allocation issues if a Canadian corporation has transactions with other branches or affiliated companies. In that case, there may be issues about the appropriate allocation of interest and other expenses.
In Canada, the maximum foreign tax credit available for foreign-source income is based on a formula: foreign-source net income divided by total income, multiplied by the Canadian tax otherwise payable.
The deductibility of interest is generally based on a tracing concept. Interest will be deductible if it was incurred for the purpose of gaining or producing income from a business or property, or for the purpose of acquiring a property that will generate income. In the United States, there are fungibility rules for the allocation of interest. If there is excess interest (for example, if interest that is allocable to the U.S. branch exceeds the interest paid by the branch), a 10 percent U.S. tax will apply to the excess interest. There is no U.S. withholding tax on a payment to a U.S. lender by the U.S. branch, or when the portfolio interest exemption applies or interest is paid to a vendor resident in Canada.
There generally would not be any Canadian withholding tax on nonparticipating loans relating to the U.S. branch. Paragraph 212(1)(b)(vii) of the ITA provides an exemption for an arm's-length loan that is not a participating loan. There is another exemption under subparagraph 212(1)(b)(viii) for a loan secured with non-Canadian real estate (that is, U.S. real estate). There is an exemption in clause 212(1)(b)(iii) for funds borrowed and used in a business. Finally, Article XI of the Canada-U.S. tax treaty exempts from Canadian withholding tax interest paid to a U.S. resident entitled to the benefits of the treaty even if the parties do not deal at arm's length.
In computing the income of a branch for Canadian tax purposes, the income must be calculated in Canadian dollars, based on an average exchange rate. Any resulting foreign exchange gain will be taxable as ordinary income rather than a capital gain in Canada.
The major drawback of a branch is the inability of the Canadian corporation to transfer the assets of the U.S. branch to a U.S. subsidiary on a tax-deferred basis. That is problematic if the value of the U.S. branch's assets exceeds the tax cost. For Canadian tax purposes, the transfer would be deemed to occur at fair market value, with the result that there could be a gain on the sale of goodwill and other assets. If a U.S. branch is to have start-up losses, the Canadian corporation may consider using a branch and transferring the assets to a U.S. corporation before the U.S. branch has any value in excess of its tax cost (but after taking advantage of initial losses).
It is possible to roll over a U.S. branch to another Canadian company using section 85 of the ITA and IRC section 351. The transfer may trigger branch tax on the earnings of the original branch. To the extent that a determination has been made to operate a U.S. branch and that issues are encountered regarding the fungibility of expenses when the Canadian corporation has other branches, it may be worthwhile to roll over the U.S. branch to a single-purpose Canadian company that does not own any other assets.
A U.S. subsidiary may also be converted to a branch without Canadian or U.S. tax. There would be a deemed sale of excluded property, assuming that the U.S. subsidiary was carrying on an active business. That would create exempt surplus for Canadian tax purposes and could be structured as a tax-free U.S. liquidation under IRC sections 332, 337, and 367(e). The conversion of a subsidiary to a branch may be considered when the U.S. subsidiary continually incurs losses that cannot be deducted by the Canadian parent corporation.
The normal Canadian and U.S. tax rules for the sale of an asset would apply to the sale of a U.S. branch. There is no U.S. branch tax if there is a total sale of all the assets of the branch and if the other requirements of the branch termination rules are satisfied. There is no treaty protection to exempt a Canadian vendor from U.S. tax arising on the sale of the assets comprising the branch. A foreign tax credit would be claimed in Canada.
Foreign Accrual Property Income
Canada's FAPI rules are designed to tax Canadian taxpayers on the undistributed passive income of controlled foreign affiliates. A foreign affiliate is a nonresident corporation in which the taxpayer's equity percentage is not less than 1 percent, and total equity percentage owned by the taxpayer and related persons is not less than 10 percent. FAPI applies only if the foreign corporation is regarded as a controlled foreign affiliate (generally requiring control by a small group of Canadian taxpayers and related persons). A tax credit is available for the underlying tax paid by the foreign corporation. FAPI would be of concern if a Canadian taxpayer controlled a foreign corporation that earned income from property or carried on a business other than an active business.
In general, the FAPI of a taxpayer's controlled foreign affiliate is subject to tax on an accrual basis (rather than a distributed basis), and the adjusted cost base (or tax cost) of the shares of the foreign affiliate is increased to reflect the attributed income. Dividends received from a foreign affiliate are taxable as ordinary income unless paid to a Canadian corporate shareholder out of the exempt surplus of the foreign affiliate. Generally, if the income was previously included in the Canadian shareholder's income on an undistributed basis as FAPI, it will not be taxable when distributed and will reduce the tax cost of those shares.
FAPI typically is income from property, such as interest, dividends, royalties, and certain rents. Also included are income from a business that is not an active business and income from an excluded business. Excluded from FAPI is active business income, which does not include income from property from a business that is deemed to be a business other than an active business. For example, paragraph 95(2)(b) of the ITA may deem the income from a business to be FAPI if services are performed by a Canadian resident in relation to whom the foreign corporation is a controlled foreign affiliate or related entity.
Income from property also includes income from an investment business with the principal purpose of deriving income from property (including interest, dividends, rents, royalties, and similar returns), from the insurance or reinsurance of Canadian risks, from the factoring of Canadian trade accounts receivable, or from the disposition of investment property.
If the foreign company carries on a business with the principal purpose of earning royalties, rent, or real estate development profits, that income would generally be regarded as income from an investment business and would constitute FAPI unless the company has more than five full-time employees. Alternatively, if the foreign company is regarded as selling products, it may earn active business profits and would not be required to have more than five full-time employees actively engaged in the conduct of the business. If the foreign company holds a license for other foreign affiliates of a Canadian corporation for which foreign affiliates are carrying on an active business, the intercompany royalty payments may be deemed to be active business income under paragraph 95(2)(a) of the ITA, in which case the foreign company need not have more than five full-time employees.
Use of a U.S. Subsidiary
Article IV(3) of the Canada-U.S. tax treaty deems a corporation to be resident of the state in which it was created. To the extent a corporation is continued under the laws of another contracting state, in accordance with the corporate law of the other state, it will be deemed, while it is so continued, to be a resident of the other state. The provision is intended to ensure that corporations are not dual residents of both Canada and the U.S.
Subsection 250(5) of the ITA provides that a person who would otherwise be resident in Canada for the purposes of the ITA will be deemed not to be a Canadian resident if, at the time, the person is under a tax treaty with another country, resident in the other country, and not resident in Canada.
Article IV of the Canada-U.S. tax treaty and subsection 250(5) of the ITA ensure that a U.S. corporation that has its mind and management in Canada will not be treated as being resident in Canada. However, if a U.S. corporation has Canadian officers and directors, it may be considered to have a fixed place of business that is a place of management and a permanent establishment in Canada, according to a technical interpretation issued by the CRA. In that case, the U.S. corporation will be required to file a Canadian tax return and pay Canadian tax on the profits reasonably attributable to the PE.
There is a question about how much profit would be allocated to the Canadian operation if all the profits otherwise arose outside Canada.
Each year a determination must be made as to whether the income of the U.S. subsidiary is derived from an active business (as the term is defined for purposes of the ITA). If the U.S. subsidiary is carrying on an active business, it can pay a dividend out of exempt surplus to a Canadian corporate shareholder. A dividend received by a Canadian corporation out of exempt surplus of a foreign affiliate is not subject to Canadian tax. If the U.S. subsidiary is wholly owned by a Canadian corporation, there will be a 5 percent U.S. withholding tax on the dividend and no foreign tax credit in Canada.
It is generally recommended that a C corporation, rather than an LLC, be used as the U.S. operating subsidiary, because Canada takes the position that an LLC is not entitled to benefit from the treaty. An LLC is not subject to tax on its income, and therefore generally is not a resident for purposes of the treaty. Because the LLC is not entitled to treaty protection, it may be deemed to be resident in Canada, based on the location of its central management and control. Also, the U.S. will regard the operation of a U.S. business by a Canadian corporation through a U.S. LLC as a branch operation. The U.S. will impose U.S. corporate tax and branch tax at the rate of 25 percent (not being entitled to the reduction under Article X of the Canada-U.S. tax treaty).
If the U.S. subsidiary does not carry on an active business, its income will be added to FAPI and will be taxable in Canada on an accrued basis. For example, if the U.S. subsidiary is engaged in real estate development and has fewer than six full-time employees, it would not be engaged in an active business.
If the U.S. subsidiary carries on a branch operation in a third country that does not have a tax treaty with Canada, the U.S. subsidiary will be considered to have earned taxable surplus (assuming that the branch is engaged in an active business). Taxable surplus is not taxable when earned, but it is fully taxable in Canada when distributed to a Canadian shareholder with a credit available for underlying foreign taxes.
In some cases, it is more advantageous to form a separate Canadian holding company to own a U.S. subsidiary than to have the U.S. subsidiary directly owned by the Canadian operating company. For example, if more than 10 percent of the value of the shares of a Canadian company is attributable to the shares of a U.S. subsidiary, the Canadian corporation will no longer qualify as a qualified small business corporation. In that case, the shareholders will not be entitled to claim the C $750,000 capital gains exemption, the small business rollover will cease to apply, and the corporate attribution rules may apply to any shares of the Canadian corporation held by minor children.
If funds are advanced to the U.S. corporation at less than a reasonable rate of interest by a Canadian corporation that is not the parent corporation or in the same chain of ownership, section 17 of the ITA may impute interest to the Canadian lender. That problem may occur when other related Canadian corporations advance funds at less than a reasonable rate of interest by way of a loan or when there is a sale of goods and services without interest being charged on the outstanding balance.
In capitalizing the U.S. corporation, one must consider the U.S. thin capitalization rules (IRC section 385) that may disallow an interest deduction and impose U.S. withholding tax on the repayment of both principal and interest on the loan. Unlike the Canadian rules, the U.S. thin capitalization rules do not have a fixed debt-to-equity ratio. In the U.S., case law takes various factors into account to determine debt versus equity for tax purposes.
U.S. earnings stripping rules also must be considered when a non-U.S. parent capitalizes the U.S. subsidiary. Those rules may disallow the deduction of a portion of the interest if the net interest expense exceeds 50 percent of the adjusted taxable income (before depreciation and interest payments). There is a safe haven debt-to-equity ratio of 1.5 to 1. Any disallowed interest is carried forward (as stated in IRC section 163(j)).
A Canadian company may guarantee the loan by a U.S. lender to a subsidiary. If there is no guarantee fee, there is the possibility of an imputed guarantee fee under Canada's transfer pricing rules. A deduction may not be available for the payment made to honor the guarantee. In the U.S., a shareholder guarantee fee paid by a subsidiary may not be deductible and may be treated as a dividend subject to withholding tax. Also, based on the U.S. Plantation Patterns case,1 the U.S. may treat a guaranteed loan as being made to the guarantor and then contributed to the U.S. subsidiary as equity. Even if the guaranteed loan is treated as debt, a guaranteed loan will be treated as a loan from an exempt related person for purposes of the earnings stripping rules.
There is more flexibility in reorganizing a U.S. subsidiary than a U.S. branch. As indicated above, a sale of assets by the U.S. subsidiary followed by a liquidation would trigger U.S. corporate tax, but would preclude U.S. withholding tax. There would be no Canadian tax on the distribution because the sale of assets of an active business would be regarded as a sale of excluded property and would increase the exempt surplus of the U.S. subsidiary. An election would be made under subsection 93(1) of the ITA to treat the liquidation proceeds as a deemed dividend rather than a disposition of shares.
It is possible to transfer the shares of the U.S. subsidiary to a Canadian company under subsection 85(1) of the ITA. Provided that the U.S. subsidiary is not a real estate company, there would be no U.S. tax on the accrued gain.
It is also possible to interpose a non-Canadian holding company between a Canadian parent and its U.S. subsidiary on a tax-deferred basis. Subsection 85.1(3) of the ITA permits a tax-deferred transfer, provided the interposition of the holding company is not part of a series of transactions involving the sale of shares of the U.S. subsidiary. Article XIII of the Canada-U.S. tax treaty would provide a capital gains exemption. A subsequent sale of the shares of the U.S. company may not be taxable in the U.S. Also, the sale of U.S. shares by the non-Canadian holding company may be a sale of excluded property and not be taxable in Canada until repatriated. Under current law, half of the gain would be added to exempt surplus. Recent amendments propose that such gain would constitute hybrid surplus and that the Canadian company would be taxable on half of the dividends received that are purchased out of hybrid surplus.
If a U.S. subsidiary is merged with another U.S. company, a tax-deferred transfer may be permitted under paragraph 95(2)(c) of the ITA. The U.S. nonrecognition rules would have to be reviewed to ensure that no U.S. tax arises.
On the sale of shares of a U.S. subsidiary by a Canadian parent, a capital gain will arise in Canada unless an election is made under subsection 93(1) of the ITA to treat the sale of shares as a dividend out of exempt surplus. Article XIII of the Canada-U.S. tax treaty would protect the resulting gain from U.S. tax, provided that the underlying assets of the subsidiary were not primarily real estate.
Advantages of a Subsidiary
A U.S. subsidiary is generally more advantageous than a U.S. branch for the following reasons:
- It avoids branch accounting.
- It avoids U.S. fungibility rules for the allocation of expenses.
- It is possible to delay withholding tax until a distribution is made. That is not the case when U.S. branch taxes apply.
- It is possible to avoid the 5 percent withholding tax on dividends if the subsidiary is liquidated when the distribution is to be made.
- Creative tax planning is possible regarding the capitalization of the U.S. subsidiary.
- Accounting is simplified by having a separate legal entity operate the business.
- By interposing a non-Canadian holding company or structuring a subsequent sale of the business as an asset sale, it is possible to defer Canadian tax by taking advantage of the excluded property rules in the ITA.
- If the U.S. subsidiary earns active business income, the income will not be taxable in Canada until distributed to Canada, because the FAPI rules will not apply. For a branch, the income is taxable in Canada when earned.
- It is possible to license a subsidiary (but not a branch) and take advantage of the withholding tax exemption in the treaty on royalties. The payment of a reasonable license fee would create a deduction for U.S. tax purposes.
- U.S. replacement property rules would apply, enabling the U.S. subsidiary to sell real property used in its business and to acquire a larger property without triggering U.S. tax. Note that the U.S. replacement property rules in IRC section 1031 will be attractive only when the U.S. subsidiary is carrying on an active business and does not earn any income that would be treated as FAPI.
- The U.S. permits consolidated reporting if a U.S. corporation owns at least 80 percent of the shares of other U.S. corporations. That simplifies U.S. federal tax compliance and allows losses of the subsidiaries to be applied against each other for federal tax purposes. Separate state tax returns are still required.
The disadvantages of a subsidiary are the cross-border transfer pricing issues that arise in both the U.S. and Canada. Also, U.S. losses cannot be deducted against Canadian-source profits. Finally, there is an exception from branch tax in Article X(6) of the Canada-U.S. tax treaty for the first $500,000 of profit that is not available for dividend withholding tax.
If a Canadian corporation is purchasing shares of a U.S. C corporation, a direct acquisition may be considered. However, tax effective financing (outlined below) may necessitate the formation of a U.S. C corporation to be the vehicle that purchases the shares of the target. If a C corporation is formed to purchase shares of the target (which may be a C corporation, an S corporation, or an LLC), it may be used to purchase the shares of other U.S. C corporations and would benefit from consolidated reporting for U.S. federal taxes. Direct or indirect financing to the U.S. C corporation that is the acquisition vehicle may enable interest expense relating to the funds borrowed for the acquisition to be deducted in the U.S. against U.S. income. The interest if payable to a Canadian resident shareholder will not be subject to U.S. withholding tax (either because of the portfolio interest exemption or Article XI of the Canada-U.S. tax treaty).
A C corporation should be formed where assets are to be purchased. As indicated above, a Canadian corporation should not form a U.S. LLC to act as the acquisition vehicle. In addition to its branch tax problem outlined above, the treaty would also deny reduced withholding tax rates on interest, royalties, and dividends paid by the LLC to the Canadian resident. There is also a risk of the LLC being a resident of Canada if its central management and control is exercised in Canada. The saving provision in Article IV(3)(a) of the Canada-U.S. tax treaty, which deems a corporation formed in the U.S. to be a resident of the U.S., would not apply to an LLC.
A major decision in structuring a U.S. acquisition concerns the manner in which the investment is financed -- this issue focuses on the deductibility of interest payments and whether they are subject to withholding tax.
In general, interest on funds borrowed to purchase income-producing property is deductible in Canada. Under paragraph 20(1)(c) of the ITA, interest is deductible if it relates to the acquisition of common stock in a U.S. company.
Section 17 of the ITA should be considered if a Canadian corporation uses its retained earnings to make interest-free loans to nonresident persons. If the loan is outstanding for more than a year and interest is computed at an unreasonably low rate, the lender is deemed to have received interest at a prescribed rate for the period in the year during which the loan was outstanding. This imputation rule does not apply if the borrower is a subsidiary and the money was used in its business to produce income.
Subsection 15(2) of the ITA taxes loans made to a shareholder (or a person connected to a shareholder) if the loan:
- remains unpaid at the end of the fiscal year after the year in which the loan was made; and
- does not fall into a specific list of exceptions (for example, an employee loan to buy treasury shares, cars, or residences).
There is an exception for loans made between Canadian corporations; however, if a loan is made by a Canadian corporation to a U.S. corporation owned by a Canadian individual, the loan might be treated as a shareholder loan.
As for the deductibility of interest payments in the U.S., the IRC has intricate interest allocation rules and limitations on interest deductions that may add uncertainty and complicate compliance. Canadian corporations must allocate interest payments for U.S. purposes on a fungible basis instead of a tracing basis. The amount of interest that is deductible in the U.S. may differ from the amount deductible in Canada. This problem may be avoided by having the U.S. business be owned by a single purpose Canadian corporation, rather than a company with multiple investments.
The U.S. thin capitalization rules must also be considered. Unlike their Canadian equivalent, the U.S. rules contain no fixed debt-to-equity ratio; thus, a loan's recharacterization as capital can result in the disallowance of interest deductions and the interest payments being treated as dividends subject to U.S. withholding tax.
There is generally no U.S. withholding tax on U.S.-source interest paid to a Canadian lender under the treaty.
The U.S. earnings stripping rules in IRC subsection 163(j) may preclude the deduction of interest, if the interest expense less interest income exceeds 50 percent of the adjustable taxable income. The rules specify a safe harbor debt-equity ratio of 1.5 to 1.
The Canadian and U.S. transfer pricing rules must also be considered in determining the interest rate on any loan. However, if the loan is made by a Canadian parent to a U.S. subsidiary that is a controlled foreign affiliate within the narrower definition in subsection 17(15) of the ITA, Canada's transfer pricing rules generally should not apply.
Financing Alternative -- Tower Structure
A Canadian corporation owning a U.S. company that carries on an active business may finance the U.S. business using the structure outlined below. This arrangement permits both the Canadian and the U.S. operating companies to deduct interest payments.
In order to provide the required financing to a U.S. corporation that is a subsidiary of a Canadian parent corporation that has taxable income, the following structure may be put in place for an active business in the U.S.:
- The Canadian parent of the U.S. operating company and a Canadian subsidiary of the Canadian parent form a U.S. partnership under the laws of Delaware. The Canadian parent is the general partner in U.S. Partnership.
- U.S. Partnership elects to be a U.S. corporation for U.S. tax purposes.
- U.S. Partnership forms an unlimited liability company (ULC) under the laws of Nova Scotia, British Columbia, or Alberta.
- ULC forms an LLC under the laws of Delaware.
- U.S. Partnership arranges a U.S. loan with a U.S. lender.
- U.S. Partnership uses the borrowed money to subscribe for shares of ULC.
- ULC uses the funds it receives from the share subscription of U.S. Partnership to make a capital contribution in LLC.
- LLC loans the funds to the U.S. operating company (the second loan) on a demand basis at an interest rate that is 1 percent per annum in excess of the interest charged on the loan.
The U.S. operating company pays interest on the second loan to LLC that is deducted by the U.S. company in the U.S. in computing its income for U.S. income tax purposes. It is assumed that both the U.S. thin capitalization and earnings stripping rules are respected. No U.S. withholding tax arises, since the U.S. operating company is considered to pay interest to a U.S. corporation, which pays interest to a U.S. lender.
LLC distributes the interest it receives from the U.S. operating company to ULC.
ULC distributes the funds it receives from LLC to U.S. Partnership, which in turn uses the funds to satisfy its obligations under the loan.
Canadian Tax Consequences
Interest paid by the U.S. operating company to LLC regarding the second loan will be included in computing income from an active business for the LLC's tax year under clause 95(a)(ii)(A) of the ITA. The Canadian parent has a qualifying interest in the U.S. operating company, and LLC and ULC are related to the Canadian parent. As a result, the qualifying interest test is met through the interaction of paragraphs 95(2)(m) and (n) of the ITA. The CRA has consistently ruled that interest income earned by a controlled foreign affiliate from financing other controlled foreign affiliates that carry on an active business is deemed to be active business income under subparagraph 95(a)(ii)(A) of the ITA.
The CRA has consistently taken the position that LLCs formed in U.S. jurisdictions are corporations for purposes of the ITA. It has further stated that distributions from LLCs to a Canadian owner are to be regarded as dividends. The CRA has stated in several technical interpretations that a Tennessee LLC is considered to be a corporation and the owners are considered to be shareholders. Each amount distributed on account of profits by the Tennessee LLC to its owners will be considered to be a dividend for purposes of the ITA and the regulations made thereunder. Accordingly, distributions made by the LLC to a Nova Scotia ULC (NSULC) should be dividends for purposes of the ITA.
It is important that the LLC be resident in the U.S. for Canadian tax purposes -- in other words, its central management and control must be in the U.S. The manager of the LLC should be a U.S. resident; if the manager is a Canadian resident, the LLC may be deemed to be resident in Canada.
Dividends received by a corporation resident in Canada (in this case, ULC) from a foreign affiliate (in this case, LLC) are included in the income of the Canadian corporation (in this case, ULC) under section 90 of the ITA; however, to the extent they are paid out of exempt surplus, the dividends are deductible in computing income in Canada (see subsection 113(1) of the ITA). Exempt surplus of a foreign affiliate includes the exempt earnings of the foreign affiliate during the tax year ending in the period. Exempt earnings include the particular affiliate's net earnings for the year. Net earnings of an affiliate resident in a treaty country include the affiliate's earnings for the year from an active business carried on in a treaty country (in this case, the U.S.), less the portion of any income or profits tax that is paid to the government of a country for the year by the affiliate that can reasonably be regarded as tax regarding those earnings. Accordingly, income earned by the LLC and distributed to ULC is considered to be a dividend out of exempt surplus, a dividend that is deductible by the ULC in computing its income for purposes of the ITA.
Dividends paid by ULC to U.S. Partnership are not subject to any Canadian tax. U.S. Partnership will be regarded as a Canadian partnership for purposes of the ITA, under the definition in subsection 102(1) of the ITA. Under the provisions of subsection 96(1) of the ITA, a partnership computes its income as if it were a person resident in Canada. However, the partnership itself is not a taxpayer. Instead, it flows out to its partners according to their proportionate share of the income or loss of the partnership, and the income or loss maintains its source and character in the hands of the partners.
The dividends received indirectly by the Canadian corporate partners through U.S. Partnership from ULC are included in computing income under Part I of the ITA, but will be deductible under subsection 112(1). Accordingly, there is no Part I tax on the dividends received by the Canadian companies indirectly from ULC.
There is no Part IV tax payable by the Canadian corporate partners regarding the dividends received indirectly from ULC. Subsection 186(6) of the ITA provides that for purposes of Part IV, all amounts received in a fiscal period by a partnership as taxable dividends are deemed to have been received by each member of the partnership in the member's fiscal period or tax year in which the partnership's fiscal period ends, to the extent of that member's share thereof. Also, each member of the partnership is deemed to own a proportionate number of shares of the corporation and of other property of the partnership that represent that member's share of the dividends received on those shares by the partnership. Accordingly, ULC is connected with the Canadian parent and there will be no Part IV tax. Similarly, the subsidiary of the Canadian parent is connected with ULC, since more than 50 percent of the issued share capital of ULC is deemed to belong to the Canadian parent, with which the Canadian subsidiary does not deal at arm's length.
Interest paid by U.S. Partnership is deductible in computing its income under paragraph 20(1)(c) of the ITA, which provides that an amount paid in the year, or payable regarding the year, under a legal obligation to pay interest on money borrowed or an amount payable for property acquired for the purpose of gaining or producing income from the property, or for the purpose of gaining or producing income from a business, is deductible in computing income to the extent it is reasonable in the circumstances. The loan is used by U.S. Partnership for the purpose of acquiring the common shares in ULC. The CRA has taken the position that interest expense incurred to acquire common shares is deductible in computing income. The jurisprudence has clearly established that the purpose test focuses not on the purpose of borrowing, per se, but rather on the direct use of the borrowed money. The objective of subparagraph 20(1)(c)(i) of the ITA is to create an incentive to accumulate capital with the potential to produce income. The partnership will borrow for the purpose of producing income from the U.S. operating company's business. It is clearly established that the provision requires tracing the use of borrowed funds to an eligible use -- in this case, the purchase of the common shares of ULC.
U.S. Partnership computes its income as if it were a person resident in Canada. In computing their income, the corporate partners include a proportionate share of the income or loss of U.S. Partnership for the tax year in which the fiscal year of the partnership ends. Since U.S. Partnership incurs a loss regarding interest payments made under the loan, such loss would be deductible by the corporate partners in accordance with their respective proportionate share.
It remains a fundamental principle of Canada's tax law that a taxpayer is entitled to arrange his affairs in order to minimize the amount of tax payable.
The ITA encourages the use of a financing affiliate by deeming what would otherwise be income from property to be active business income, in order that the funds may be repatriated to Canada as a dividend out of exempt surplus. In 1995, when the foreign affiliate rules in the ITA were revised, clause 95(2)(a)(ii) was retained and continued to recharacterize property income as active business income. The fundamental policy objective underlying subparagraph 95(2)(a)(ii) of the ITA has not changed -- specifically, that FAPI should not arise in a foreign affiliate regarding charges to another foreign affiliate, if the charges are deductible in computing the payer's earnings or loss from an active business. The combined effect of clause 95(2)(a)(ii)(A) of the ITA and the exempt surplus rules (see the definition of net earnings in regulation 5907(1)) is to make it acceptable from a policy standpoint to reduce the income of the U.S. operating company that is subject to tax in the U.S., without the interest income being subject to Canadian tax, even if it is repatriated to Canada.
The Canadian parent would clearly have been entitled to an interest deduction in Canada if it borrowed funds to invest in the U.S. operating company by way of shares or loans. As the Supreme Court of Canada noted in Shell Canada Ltd. v. Canada,  3 S.C.R. 622, at paragraph 43:
This Court has consistently held that courts must . . . be cautious before finding within the clear provisions of the Act an unexpressed legislative Intention . . . Finding unexpressed legislative intentions under the guise of purposive interpretation runs the risk of upsetting the balance Parliament has attempted to strike in the Act.
At the 2003 Canadian Tax Foundation Annual Conference, the CRA confirmed that it would not be inappropriate for a Canadian company that has profits to invest in preference shares of an affiliated loss company and to have the loss company loan the same funds back to the parent at interest. The net effect of the transaction is to create a deduction in the profitable company and interest income in the loss company. Planning within an affiliated group using interest expense is not regarded as abusive. At the Canadian International Fiscal Association meeting in 2005, the CRA responded to technical questions involving the financing structure outlined above and did not indicate that the structure is abusive.
In 2007 the ITA was amended effective in 2011 with a view to closing the tower structure. However, as a result of lobbying by corporate Canada and a government report, the amendment was repealed in 2009, before it took effect.
- The Canadian corporation (Canco) will form a U.S. C corporation in Delaware (Holdco).
- Holdco will form a separate U.S. C corporation for each U.S. acquisition (Opco). Holdco and the Opcos will file consolidated federal tax returns in the U.S. This structure allows each Opco to have limited liability, enables dividends to be paid by the Opcos to Holdco free of U.S. tax, and facilitate an effective financing structure (below).
- Canco will borrow funds. Canco will invest the funds it borrowed to buy common shares in Holdco. Canco will deduct in computing its income the interest on funds it borrowed.
- Holdco will purchase preference shares with a cumulative dividend (repo shares) and common shares in each Opco. The dividend on the preference shares should not exceed 50 percent of the adjusted taxable income for earnings stripping purposes of the Opcos.
- Each Opco will purchase the assets of the U.S. businesses.
- Canco will purchase the repo shares of the Opcos from Holdco in satisfaction of the loan from Canco to Holdco.
- As part of the share sale to Canco, Holdco will undertake to repurchase the repo shares in five years.
- For U.S. tax purposes, the repurchase obligation by Holdco will recharacterize the repo shares as debt for U.S. tax purposes. When the Opcos pay dividends to Canco on the repo shares, it will be treated as an interest payment by Holdco. With U.S. consolidated reporting, the interest will be deductible against the income of Opcos.
- The deemed interest on the repo shares paid will be exempt from U.S. withholding tax under Article XI of the Canada-U.S. tax treaty.
- Dividends paid by Holdco to Canco will be subject to U.S. withholding tax at the rate of 5 percent under Article X of the Canada-U.S. tax treaty.
- For Canadian tax purposes, the dividends paid to Canco on the repo shares of the Opcos or on the common shares of Holdco will be dividends out of exempt surplus (because they are derived from an active business carried on in the U.S.) and effectively will not be taxed to Canco. No foreign tax credit will be available in Canada for the 5 percent withholding tax on any dividends from Holdco. However, there is no U.S. withholding tax on the dividends on the repo shares as they are recharacterized as interest in the U.S.
- The dividends out of exempt surplus will increase the general rate income pool of Canco and may be paid in the future as eligible dividends (taxed at a lower rate) to Canadian resident shareholders.
- If Canco subsequently sells Holdco, there will be no tax payable in the U.S. by virtue of Article XIII of the Canada-U.S. tax treaty. Canco would be taxable in Canada on any capital gain realized on the shares of Holdco. If Holdco has exempt surplus at the time of sale, Canco can reduce the tax in Canada by electing under subsection 93(1) of the ITA.
Use of Luxembourg Finance Company
- Canco borrows funds from a bank to finance a U.S. acquisition.
- Canco forms CanSub and invests a small amount in share capital.
- Canco makes an interest-free loan to a subsidiary, CanSub. CanSub then invests a sufficient portion of the proceeds in shares of U.S. Holdco to avoid the U.S. earnings stripping rules.
- Canco invests a small amount in shares of a newly formed Luxembourg SARL.
- Canco makes an interest-free loan of the balance of the funds to CanSub. The rate of interest on this loan will exceed the rate of interest on the borrowed funds.
- CanSub makes an interest-free loan to SARL.
- SARL lends the funds with interest to U.S. Holdco formed to purchase either the shares of U.S. C corporation or the assets. The rate of interest must be reasonable and equivalent to an arm's-length interest rate.
- U.S. Holdco will use the funds borrowed from SARL, any third-party borrowings, and its equity to purchase the shares of U.S. C corporation.
- For U.S. tax purposes, interest paid by U.S. Holdco to SARL should be deductible and should not be subject to U.S. withholding tax. There is no U.S. withholding tax on interest payments under the Luxembourg-U.S. tax treaty. Because the Luxembourg-U.S. tax treaty also contains an exemption from withholding tax on interest payments, the derivative benefits exemption from the limitation on benefits provision of the treaty will apply.
- SARL is taxable on the interest it receives but can deduct imputed interest on the interest-free loan from CanSub.
- For Canadian tax purposes, interest received by SARL should be recharacterized as active business income.
- Dividends paid by SARL to CanSub should be tax-free dividends out of exempt surplus.
- Interest is deducted by U.S. Holdco in the U.S. without any entity in the structure (being taxable on the interest income (except for a small spread in SARL).
- Dividends paid from CanSub to Canco will be tax-free intercorporate dividends and eligible dividends, which can be added to Canco's general rate income pool.
- Canco will service the loan and deduct the interest expense in Canada.
For U.S. purposes, intangibles, noncompete payments, and goodwill are amortized ratably over 15 years.
Depreciable property is depreciated over the useful life subject to exceptions. A vendor may have recaptured income.
Accounts receivable will only be taxed if an amount is collected in excess of what was paid for the receivables.
The vendor can be a source of financing when the vendor agrees to be paid over time. In the U.S. the vendor may defer tax when there is an installment sale. This rule can also apply to any holdback. It is common in the purchase of a business to hold back part of the purchase price until it is determined that there is no undisclosed liability. The vendor is allowed to report the gain when funds are paid. The vendor may want the balance of sale to be guaranteed.
If there is a dispute over value, an earn-out or contingent payment sale should be considered. Part of the purchase price may be based on future earnings. The U.S. original issue discount and imputed interest rules may apply.
1 Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (5th Cir. 1972).
END OF FOOTNOTE
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