CRA Confirms Luxco Financing Structure
Consider a Canadian company with a foreign operating subsidiary in a country with which Canada has a tax treaty. Dividends paid by the subsidiary to the Canadian parent will generally be considered to be paid out of the subsidiary's available exempt surplus, and thus will be effectively tax-free in Canada. One way to improve the tax result for the foreign operating subsidiary while preserving the favourable Canadian tax treatment of the parent company is to finance the foreign operating subsidiary through a Luxembourg entity. In a recent advance tax ruling (2010-0375111R3), the CRA confirms the commonly understood Canadian tax consequences of such treaty-based Luxembourg financing structures.
The ruling involves a Canadian public corporation (Pubco) with two wholly owned foreign subsidiaries: an operating company (Opco) in country A and a Luxembourg financing entity (Luxco). In the proposed transaction, Pubco was to transfer to Luxco certain interest-bearing debt instruments issued by Opco in exchange for Luxco issuing mandatory redeemable preferred shares to a Luxembourg branch of Pubco.
The non-Canadian tax aspects of this structure are outside the scope of the ruling, but generally Opco would obtain a tax deduction in country A for interest payments (withholding taxes may apply), and Luxco would only be subject to tax in Luxembourg on the financing margin for the interest income on the debt.
The financing structure results in a reduction in Opco's tax payable in country A; the interest payments made under the structure are generally deductible to Opco, while the dividend payments they replace are not. As discussed below, the favourable Canadian tax treatment of the parent company--that is, the tax-free receipt of dividends--continues under the financing structure.
The ruling concerns the tax consequences to Pubco. It confirms that the interest income earned by Luxco for the debt would be included in computing Luxco's income from an active business under clause 95(2)(a)(ii)(B) because the interest would be deductible by Opco in computing its earnings from an active business other than a business carried on in Canada. Accordingly, such income would be added to Luxco's "exempt earnings" and "exempt surplus," as those terms are defined in regulation 5907(1), presumably on the basis that Opco was resident in a country with which Canada either has entered into a tax treaty or has a TIEA. Therefore, pursuant to subsection 113(1), Pubco would not be taxable on dividends distributed by Luxco out of its exempt surplus.
The ruling also says that subsection 95(6) (a specific foreign affiliate anti-avoidance rule) and subsection 245(2) (GAAR) would not apply as a result of the proposed transactions. Specifically, the CRA had suggested at the Canadian Tax Foundation's 2004 annual conference that it might consider applying subsection 95(6) when a taxpayer transfers an interest-bearing loan from Canada to a foreign affiliate financing structure. Therefore, the CRA's ruling on the application of subsection 95(6) and GAAR is welcome, and it should provide comfort for those dealing with treaty-based financing structures in general.
The CRA also commented on the situation in which the debt had a value below its principal amount, perhaps because Opco was in financial difficulty. The ruling notes that paragraph 40(2)(e.1) would apply to deem the loss on the transfer to be nil, with a corresponding addition to the ACB of the debt transferred to Luxco.
The logic of the ruling appears to suggest that similar Canadian tax results would result from treaty-based financing structures in other countries, such as Switzerland, Barbados, and the Netherlands.
KPMG LLP, Vancouver