Retroactive Effects of the Proposed Amendment to the Definition of “Relevant Tax Factor”

On August 9, 2022, the Department of Finance released draft legislation to implement measures previously announced in the 2022 federal budget. That draft legislation proposes to reduce the “relevant tax factor” (RTF) for a CCPC or a substantive CCPC (both types are referred to in this article as “a CCPC”) from 4 to 1.9, effective for taxation years commencing on or after April 7, 2022. The draft legislation also includes related amendments to the definitions of “capital dividend account” (CDA) and “general rate income pool” (GRIP). As we discuss below, the proposed amendment to the definition of RTF has significant retroactive effects.

Background

There are two points in time when the definition of RTF is relevant in calculating the amount of relief provided to a Canadian taxpayer for foreign taxes paid by its FA.

First, when the Canadian taxpayer has an income inclusion under subsection 91(1) for foreign accrual property income (FAPI) earned by its controlled foreign affiliate (CFA), it is entitled to a deduction, under subsection 91(4), that is equal to the RTF multiplied by the foreign tax paid in respect of the FAPI. The net income inclusion is subject to Canadian tax (as “aggregate investment income” [AII], which is subject to high-rate refundable tax if the recipient is a CCPC) and is added, under subsection 92(1), to the ACB of the shares of the Canadian taxpayer’s CFA.

Second, when a Canadian corporation receives a dividend from its FA that is paid out of the FA’s “hybrid surplus” or “taxable surplus” pool (the latter pool includes previously imputed FAPI less foreign tax paid thereon), the Canadian corporation is entitled to (1) a section 113 deduction based on the RTF and the foreign tax paid, and (2) a deduction under subsection 91(5) to the extent of a previous ACB addition under subsection 92(1). The portion of the dividend that is deductible is generally included in a taxpayer’s GRIP and is not AII of a CCPC.

The policy objective of the proposed amendment to the definition of RTF is to have a CCPC or its CFA pay tax on passive income earned by the CFA at a rate of roughly 52.63 percent (that is, a rate of 1/1.9), which is close to the rate the CCPC would pay if it earned passive income directly rather than through the CFA. In other words, the proposed amendment is intended to prevent a CCPC from deferring tax on passive income by earning it indirectly (through a CFA) rather than directly. The non-deductible portion of the dividend received by a CCPC from its FA continues to be included in AII and therefore is subject to high-rate refundable tax. The actual effective tax rate on FAPI earned by the CFA of a CCPC will depend on the provincial tax rate that applies to the CCPC.

To maintain integration, the proposed amendments to CDA and GRIP include the portion of a dividend from an FA that is deductible under section 113 (less the foreign withholding tax) in the CCPC’s CDA and not in its GRIP. The CDA can then be paid out to individual shareholders without personal-level tax.

Retroactive Effects of the Proposed Amendment

The proposed amendment to the definition of RTF has at least two retroactive effects.

First, the proposed amendment effectively imposes a “repatriation tax” on previously earned, unrepatriated FAPI. Such a tax is inconsistent with the longstanding policy of taxing FAPI in the year in which it is earned rather than when it is repatriated.

Assume that, prior to the proposed amendment, the CFA of a CCPC earned FAPI and paid foreign tax of approximately 25 percent when it was earned, such that the CCPC had no net FAPI inclusion (based on an RTF of 4). After the proposed amendment, the CCPC will be subject to significant tax when the CFA repatriates that previously earned FAPI to the CCPC by way of a taxable surplus dividend (based on an RTF of 1.9).

Under the old rules, the CCPC would have been entitled to a paragraph 113(1)(b) deduction equal to three times the foreign tax paid (RTF − 1 = 4 − 1 = 3) upon repatriation. Therefore, if the CFA had previously earned $100 of FAPI and paid 25 percent foreign tax thereon, the CCPC would have been entitled to a full deduction (that is, 3 × $25 = $75) of the $75 dividend upon repatriation.

After the proposed amendment, however, the CCPC is entitled to a paragraph 113(1)(b) deduction of only 0.9 times the foreign tax paid (RTF − 1 = 1.9 − 1 = 0.9) upon repatriation. Therefore, the CCPC is entitled to deduct only $22.50 (that is, 0.9 × $25 = $22.50) of the $75 dividend it receives under paragraph 113(1)(b), resulting in a $52.50 income inclusion to the CCPC that is subject to high-rate refundable tax. There is no ability to claim a deduction under subsection 91(5) because there was no net FAPI inclusion (and, therefore, no ACB addition) in the year in which the FAPI was earned.

If the proposed amendment is not modified to eliminate this repatriation tax, it is likely that many CCPCs that have CFAs with previously earned, unrepatriated FAPI will choose not to repatriate those funds to Canada (or will at least defer doing so until their individual owners want to take funds out of the CCPC that would otherwise be subject to personal-level tax). This choice may have an adverse effect on investment in Canadian businesses.

CCPCs that nevertheless choose to (or have to) repatriate previously earned FAPI will need to model the tax results under various alternative scenarios—including a taxable surplus dividend, a share redemption, a subsection 88(3) liquidation and dissolution of the CFA, and certain elective mechanisms—to determine whether it is possible to mitigate, in part, the retroactive effects.

The second retroactive effect of the proposed amendment is that, even though the amendment applies to taxation years commencing after April 7, 2022, it can also apply to FAPI earned or realized before that date, given that a CCPC may have a different taxation year than its CFA. Assume, for example, that a CCPC has a June 30 taxation year-end and that its CFA has a December 31 taxation year-end. If the CFA earned significant FAPI (for example, a large capital gain on non-excluded property) in January 2022 (that is, before the proposed amendment was announced), that FAPI would be included in the CCPC’s income at the CFA’s December 31, 2022 year-end, which would be included in the CCPC’s June 30, 2023 year-end. The CCPC’s taxation year ending June 30, 2023 would be subject to the proposed amendment.

These retroactive effects are very significant because (1) the implied rate increase (that is, from 25 percent to 52.63 percent) is substantial, and (2) a significant amount of previously earned, unrepatriated FAPI may have been accumulated in a CFA. Accordingly, these effects are not analogous to the retroactive effect of routine, minor increases in tax rates.

Possible Modifications To Avoid the Retroactive Effects

Historically, the Department of Finance has tried to avoid retroactive amendments to income tax legislation because they can be fundamentally unfair to taxpayers and can erode confidence in the tax system. To avoid the retroactive effects described above, the coming-into-force provisions should be drafted to allow CCPCs to elect to have the old rules (that is, the old RTF, CDA, and GRIP rules) apply to FAPI earned in the taxation years of the CFA that end before April 7, 2024, and to foreign tax paid thereon. Such measures would allow CFAs to repatriate previously earned FAPI under the old rules and to avoid the retroactive application of the rules to FAPI earned before the proposed amendment was announced. Similar grandfathering measures have been used in other legislative contexts, especially in the cross-border context (for example, for upstream loans).

Christopher Montes and John Farquhar
Felesky Flynn LLP, Calgary