When Do the Stop-Loss Rules Apply? Transactions Involving Foreign Affiliates After the 2012 Technical Bill

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1 canadian tax journal / revue fiscale canadienne (2016) 64:3, When Do the Stop-Loss Rules Apply? Transactions Involving Foreign Affiliates After the 2012 Technical Bill Jim Samuel* PRÉCIS Le projet de loi C-48, Loi de 2012 apportant des modifications techniques concernant l impôt et les taxes, a ouvert la voie à une nouvelle ère pour les règles sur la minimisation des pertes dans le contexte des opérations impliquant des sociétés étrangères affiliées. Cet article, qui s appuie sur les concepts de base présentés dans un article précédent du même auteur, explore les développements subséquents des règles sur la minimisation des pertes, en particulier les modifications importantes qui leur ont été apportées dans le projet de loi technique. ABSTRACT Bill C-48, the Technical Tax Amendments Act, 2012, ushered in a new era of stop-loss rules in the context of transactions involving foreign affiliates. Building on the basic concepts discussed in an earlier article by the same author, this article explores subsequent developments in the stop-loss realm in particular, the significant stop-loss-related changes that were included in the 2012 technical bill. KEYWORDS: STOP-LOSS RULES n FOREIGN AFFILIATES n FOREIGN EXCHANGE n SURPLUS n FAPI n LOANS CONTENTS Introduction 562 Overview of the 2012 Technical Bill 563 Foreign Accrual Capital Losses 564 Subsection 39(2) and Paragraph 95(2)(g) 567 Transitional Measures in Respect of Certain Qualifying Upstream Indebtedness 573 Stop-Loss Rules and the Computation of a Foreign Affiliate s Surplus Pools 577 Liquidation of a Foreign Affiliate 581 Liquidations of First-Tier Foreign Affiliates 581 Liquidations of Lower-Tier Foreign Affiliates 585 * Of KPMG Canada, Calgary ( jjsamuel@kpmg.ca). I am grateful for the assistance of Tim Fraser of KPMG LLP with the preparation of this article. Any errors are my responsibility. 561

2 562 n canadian tax journal / revue fiscale canadienne (2016) 64:3 Rollover Provisions Applicable to Transfers of Foreign Affiliate Shares with Inherent Losses 589 Section 93 Direct and Indirect Dispositions of Foreign Affiliate Shares 591 Conclusion 599 Postscript 600 INTRODUCTION Depending upon the facts, the disposition of shares or indebtedness of a foreign affiliate of a resident of Canada, 1 or the repayment of indebtedness owed to or by a foreign affiliate, could give rise to a loss, some or all of which may be attributable to fluctuations in foreign exchange rates. Regardless of whether such a disposition or debt repayment is made to an arm s-length person, or as part of an intragroup transaction, it must be determined whether any of the stop-loss rules apply to suspend or deny the recognition of the loss. Stop-loss rules have been discussed in varying detail in other papers and articles (including my own article published in this journal in 2010 in which I provided a comprehensive overview of the rules in the cross-border and foreign affiliate contexts). 2 Accordingly, a detailed analysis of the stop-loss rules, and the purpose behind them, will not be undertaken here. Instead, this article builds on the basic concepts discussed in my earlier article by exploring subsequent developments in the stoploss realm and in particular the significant changes that were included in Bill C-48, the Technical Tax Amendments Act, 2012 ( the 2012 technical bill ). 3 These changes are important in the sense that they represent fundamental shifts in how stop-loss rules are applied for the purposes of computing (1) foreign exchange gains and losses of a taxpayer, (2) the Canadian tax implications arising on certain intragroup dispositions of the shares of a foreign affiliate, and (3) the foreign accrual property income 4 (FAPI) and surplus pools 5 of a foreign affiliate. 1 In general terms, a non-resident corporation is a foreign affiliate of a Canadian-resident taxpayer if the taxpayer s equity percentage in the corporation is not less than 1 percent and the total equity percentage in the corporation owned by the taxpayer and each person related to the taxpayer is not less than 10 percent. See the definition of foreign affiliate in subsection 95(1) and equity percentage in subsection 95(4) of the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as the Act ). Unless otherwise stated, statutory references in this article are to the Act. 2 Jim Samuel, Stopping the Losses: The Application of Stop-Loss Rules to Transactions Involving Foreign Affiliates (2010) 58:4 Canadian Tax Journal Bill C-48, the Technical Tax Amendments Act, 2012; SC 2013, c As defined in subsection 95(1). FAPI of a foreign affiliate includes, among other things, (1) income from property as defined in subsection 95(1) (for example, dividends, interest, rents, royalties, etc., depending on the facts and circumstances); (2) business income that is deemed under subsection 95(2) to be income from a business other than an active business (and consequently FAPI); and (3) very generally, taxable capital gains from the disposition of property that does not constitute excluded property as defined in subsection 95(1). In (Footnotes 4 and 5 are continued on the next page.)

3 OVERVIEW OF THE 2012 TECHNICAL BILL when do the stop-loss rules apply? n 563 The 2012 technical bill represents the culmination of a major restructuring of the Canadian foreign affiliate regime that principally began with the release by the Department of Finance of a large package of draft legislation on December 20, Although the Department of Finance issued numerous versions of draft legislation relating to foreign affiliates in the years after 2002, generally speaking it was not until August 2011 that amendments to the stop-loss rules were included. 7 For the purposes of this article, a stop-loss rule refers to a provision that potentially limits, via deferral, denial, or otherwise, the ability of a taxpayer or its foreign affiliate(s) to recognize and claim a loss otherwise realized. As a result of this broad interpretation of what constitutes a stop-loss rule, the discussion that follows encompasses provisions that may not necessarily be considered stop-loss rules in a traditional sense. The stop-loss measures contained in the 2012 technical bill are summarized as follows: n the addition of rules that provide for the restriction or streaming of FAPIrelated allowable capital losses of a foreign affiliate as deductible only against the taxable capital gains included in computing the affiliate s FAPI, and the introduction of a foreign accrual capital loss (FACL) as a tax attribute distinct from a foreign accrual property loss (FAPL); computing taxable income for a particular taxation year, a taxpayer resident in Canada is required under subsection 91(1) to include its participating percentage of the FAPI earned by each of its controlled foreign affiliates. Participating percentage and controlled foreign affiliate are both defined in subsection 95(1). 5 In general, a corporation resident in Canada is required to maintain exempt surplus, hybrid surplus, taxable surplus, hybrid underlying tax, and underlying foreign tax pools for each of its foreign affiliates (herein collectively referred to as surplus pools ). These pools, which are computed in accordance with part LIX of the regulations to the Act, are potentially relevant in characterizing any distribution made by a foreign affiliate to the corporation for the purposes of claiming a deduction under subsection 113(1). By virtue of the election available under section 93, surplus pools are also relevant in determining the Canadian tax consequences that arise on a disposition of foreign affiliate shares. Section 93 effectively permits, in certain circumstances, all or a portion of a taxable capital gain otherwise realized by a Canadian corporation or another foreign affiliate of the Canadian corporation (and in certain cases, a partnership) on a disposition of the shares of a foreign affiliate to be treated instead as a dividend (that is potentially eligible for an offsetting deduction under section 113). The application of section 93 is generally automatic in the case where one foreign affiliate of a Canadian corporation disposes of the shares of another foreign affiliate of the same corporation and the vending affiliate otherwise recognizes a gain in respect of that disposition. 6 Canada, Department of Finance, Legislative Proposals and Explanatory Notes Relating to Income Tax (Ottawa: Department of Finance, December 20, 2002). 7 Canada, Department of Finance, Legislative Proposals in Respect of Foreign Affiliates (Ottawa: Department of Finance, August 19, 2011).

4 564 n canadian tax journal / revue fiscale canadienne (2016) 64:3 n the narrowing of subsection 39(2) and changes related thereto; n transitional measures contained in subsection 39(2.1) and paragraph 95(2)(g.04) that relate to the settlement of certain qualifying upstream indebtedness owed by a corporation resident in Canada (or a partnership of which it is a member) to a foreign affiliate thereof (or a partnership of which such an affiliate is a member); n the switching off of certain stop-loss rules for the purposes of computing the surplus pools of a foreign affiliate; n revisions to the rules regarding the recognition of a loss on a liquidation of a foreign affiliate to which either subsection 88(3) or paragraph 95(2)(e) applies; n changes to rollover provisions applicable to intercorporate transfers of foreign affiliate shares with inherent losses; and n certain relieving measures permitting a taxpayer (or a foreign affiliate thereof ) to recognize a loss that would otherwise be denied under subsection 93(2.01) (and its companion provisions in subsections 93(2.11), (2.21), and (2.31)), on the direct (or possibly indirect) disposition of a share of a foreign affiliate. Each of these changes is discussed in more detail below. Foreign Accrual Capital Losses Prior to the 2012 technical bill, an allowable capital loss realized by a foreign affiliate on the disposition of property (other than excluded property ) 8 was deductible in computing that affiliate s FAPI, without limiting such deduction to the amount of the affiliate s taxable capital gains included therein. In other words, for the purposes of computing the FAPI of a foreign affiliate, there was no streaming of allowable capital losses against capital gains. In order to mirror the streaming treatment of capital losses against capital gains that occurs in the Canadian domestic tax context, the 2012 technical bill included amendments to the definition of foreign accrual property income in subsection 95(1) and introduced the new concept of a foreign accrual capital loss. With regard to the definition of foreign accrual property income, element E was amended to limit the amount of the deduction of allowable capital losses under that component to the amount of taxable capital gains of the foreign affiliate included in element B of the definition. 9 To the extent that a foreign affiliate has excess 8 As defined in subsection 95(1). 9 Notwithstanding this new limitation to the deductibility of allowable capital losses in computing the FAPI of a foreign affiliate for a particular taxation year, the full amount of any capital loss of a foreign affiliate in respect of non-excluded property is still generally included in computing the foreign affiliate s surplus pools in the taxation year in which the loss is recognized. For example, paragraph (b) of the definition of net earnings in regulation 5907(1) modifies the computation of amounts included in element E of the definition of foreign accrual property income in subsection 95(1) to effectively remove the limitation on the amount of allowable

5 when do the stop-loss rules apply? n 565 allowable capital losses in a year that would otherwise be deductible in computing its FAPI, but for the above-noted limitation, and that foreign affiliate is a controlled foreign affiliate 10 of the Canadian-resident taxpayer, the excess is treated as a FACL. Generally speaking, a FACL of a controlled foreign affiliate for a taxation year of that affiliate means the excess of the affiliate s allowable capital losses for the year from the disposition of non-excluded property over the affiliate s taxable capital gains from the disposition of property described in element B of the definition of foreign accrual property income in subsection 95(1) (which includes the disposition of non-excluded property and certain dispositions of excluded property). 11 For the purposes of computing the FAPI of a controlled foreign affiliate, a FACL may generally be carried back for 3 years and forward for 20 years, to be deducted against taxable capital gains included in the FAPI computed for that other year. 12 Regulation (2) contains certain restrictions and limitations on the ability to claim a FACL carried back or forward from another year. Such restrictions and limitations include n n ordering rules, similar to those in subsection 111(3) in the domestic context, that effectively limit the amount of a FACL that may be claimed in another year to the portion of such FACL that has not already been deducted in any previous year, and require FACLs to be claimed in the order in which they are incurred; 13 and a consistency or group claim rule for claiming FACLs for a relevant person or partnership 14 in respect of the taxpayer when the FAPI of the controlled capital losses that can be deducted in computing the net earnings in respect of the FAPI of a foreign affiliate, which net earnings are ultimately included in computing the affiliate s taxable surplus pool. Also see paragraph (a) of the definition of exempt earnings and exempt loss in regulation 5907(1) in respect of the non-taxable portion of a capital loss, which loss is ultimately included in computing the affiliate s exempt surplus pool. 10 As defined in subsection 95(1). In general terms, a foreign affiliate is a controlled foreign affiliate of a taxpayer if the taxpayer controls the foreign affiliate, or would control the foreign affiliate if it held at the time all shares of the foreign affiliate that are held by (1) the taxpayer; (2) persons with which the taxpayer does not deal at arm s length; (3) any four other persons that are resident in Canada ( the relevant Canadian shareholders ); and (4) any non-resident persons that do not deal at arm s length with the relevant Canadian shareholders. 11 Regulation (3). Only FAPI of a controlled foreign affiliate of a taxpayer resident in Canada is included in computing that taxpayer s income on an accrual basis under subsection 91(1). Although a foreign affiliate can earn FAPI regardless of whether that affiliate is a controlled foreign affiliate of a taxpayer, the mechanics of regulations 5903(3) and (3) are such that only a controlled foreign affiliate can carry forward (or back) a FACL or a FAPL. 12 Regulation (1) and element F.1 of the definition of foreign accrual property income in subsection 95(1). 13 Regulations (2)(a) and (b). 14 As defined in regulation 5903(6).

6 566 n canadian tax journal / revue fiscale canadienne (2016) 64:3 foreign affiliate is relevant in computing the taxable income of the taxpayer and certain (generally non-arm s-length) persons. 15 There are also continuity rules that generally provide for the preservation of FAPLs 16 and FACLs of controlled foreign affiliates upon the occurrence of certain liquidations and mergers. In particular, if paragraph 95(2)(e) applies to a liquidation and dissolution of a controlled foreign affiliate (a disposing affiliate), or paragraph 95(2)(d.1) applies to a foreign merger involving a controlled foreign affiliate, the shareholder affiliate (in the case of a liquidation and dissolution) or the new foreign corporation (in the case of a merger) is deemed to be the same corporation as, and a continuation of, the disposing or predecessor affiliate. 17 These continuity rules effectively permit a FAPL or FACL incurred by a disposing or predecessor affiliate to be claimed by the shareholder affiliate (or the new foreign corporation in the case of a merger) subsequent to the liquidation (merger). However, these rules prevent a FAPL or FACL of the shareholder affiliate (or the new foreign corporation in the case of a merger) from being carried back to reduce the FAPI of the disposing or predecessor affiliate, as the case may be. These changes generally apply in respect of capital losses of a foreign affiliate incurred in taxation years of the foreign affiliate that end after August 19, As a result, a capital loss (assuming that its recognition is not denied by any stoploss rule) arising from a disposition of non-excluded property in 2010 (or a prior taxation year) by a foreign affiliate with a calendar year-end should be fully deductible in computing the affiliate s FAPI for that year. To the extent that such a loss exceeds the affiliate s FAPI for that year and that affiliate is a controlled foreign affiliate of the taxpayer, the excess is a FAPL, as opposed to a FACL. This FAPL can be carried forward (assuming that it is not possible in the circumstances to carry it back to a prior taxation year) to offset FAPI, without limitation as to the amount of taxable capital gains included therein, of the controlled foreign affiliate for any future taxation year to which the FAPL can be carried forward, regardless of whether that taxation year ends after August 19, Regulation (2)(c). 16 A foreign accrual property loss (or FAPL) is a reference to element F of the definition of foreign accrual property income in subsection 95(1), and is computed in accordance with regulation In general, a FAPL is the amount by which the deductible elements in the definition of foreign accrual property income in subsection 95(1) for a particular taxation year in respect of a taxpayer exceeds the taxable elements thereof. A FAPL can generally be carried back for 3 taxation years and forward for 20 years. The types of losses that are relevant in computing a FAPL for a year include (1) losses from the disposition of property (other than excluded property) that can reasonably be considered to have accrued after the affiliate s 1975 taxation year (except to the extent that such losses represent unused FACLs); (2) losses from property; (3) losses from a business other than an active business; and (4) losses from a non-qualifying business. 17 Regulation 5903(5).

7 when do the stop-loss rules apply? n 567 In contrast, an allowable capital loss (assuming that its recognition is not denied by any stop-loss rule) arising from a disposition of non-excluded property after 2010 by a foreign affiliate with a calendar taxation year can only be offset against taxable capital gains that are included in computing the foreign affiliate s FAPI. In the event that such a loss exceeds the amount of taxable capital gains that are included in computing the affiliate s FAPI for that year, and the affiliate is a controlled foreign affiliate of the taxpayer, the excess is considered to be a FACL. The characterization of this excess as a FACL (as opposed to a FAPL) means that it can be deducted only against taxable capital gains of the controlled foreign affiliate that arise in a taxation year that is within the carryback and carryforward period, regardless of whether that taxation year ends on or before August 19, Subsection 39(2) and Paragraph 95(2)(g) Prior to the changes to subsection 39(2) contained in the 2012 technical bill, there was some uncertainty and debate as to the interaction between subsections 39(1) and (2), as well as the type of transactions to which subsection 39(2) applied. For example, if prior to the enactment of such changes to subsection 39(2), a loss (or gain) arose to a taxpayer on a disposition of a capital property and the loss (gain) was not solely attributable to the fluctuation in the value of a foreign currency, it was not entirely clear whether the loss (gain) was subject to bifurcation whereby (1) the economic gain or loss component, before consideration of the impact of foreign exchange, was computed under subsection 39(1); and (2) the foreign exchange gain or loss component was separately computed under subsection 39(2). 18 However, as a practical matter, there was unlikely to be a difference in many situations even if there was a bifurcation. Similarly, where a capital loss (or capital gain) arose on a disposition of property and that loss (gain) was solely attributable to foreign exchange fluctuations, 19 it was uncertain (prior to the amendment of subsection 39(2)) whether the loss (gain) should be computed under subsection 39(1) or 39(2). 20 If subsection 39(2) (as opposed to subsection 39(1)) was considered to have applied in respect of such a loss, that loss 18 For some interesting commentary regarding the debate over whether there could potentially be a bifurcation of a foreign exchange gain or loss from the overall economic gain or loss on a disposition of property, see Lincoln Schreiner and Wallace Conway, Foreign Currency Management: Some Observations & Recent Developments, in 2008 British Columbia Tax Conference (Toronto: Canadian Tax Foundation, 2008), 10:1-21, at 10:9-10; Robert A. Kopstein and Janette Y. Pantry, Foreign Exchange Issues, in Report of Proceedings of the Fifty-Fifth Tax Conference, 2003 Conference Report (Toronto: Canadian Tax Foundation, 2004), 27:1-59, at 27:24-25; and David G. Broadhurst, Foreign Exchange Planning, in Tax Planning for Canada-US and International Transactions, 1993 Corporate Management Tax Conference (Toronto: Canadian Tax Foundation, 1994), 8:1-27, at 8: For example, this might be the case where a taxpayer disposed of a foreign-currency denominated, non-interest-bearing note for proceeds equal to its principal amount. 20 The longstanding position of the Canada Revenue Agency (CRA) appears to have been that such a loss should be computed under subsection 39(2). Moreover, where a stop-loss rule

8 568 n canadian tax journal / revue fiscale canadienne (2016) 64:3 was deemed to be a loss on the disposition of a foreign currency. Since the loss was not deemed by subsection 39(2) to have arisen on the disposition of the foreign currency to any particular person, a question arose as to whether a loss determined under subsection 39(2) was subject to any applicable stop-loss rule. 21 Also, the broad wording of the former version of subsection 39(2) was such that, in certain circumstances, it could apply to permit a taxpayer to realize a gain or loss on the redemption of foreign-currency denominated shares issued by the taxpayer. For instance, in MacMillan Bloedel, 22 the taxpayer kept its financial records in Canadian dollars and issued preferred shares that were redeemable for a fixed US dollar amount. Because of currency fluctuations, the taxpayer paid more (in Canadian dollars) on redemption than it did on the issuance of the shares. The difference was treated by the taxpayer, and ultimately allowed by the Federal Court of Appeal, as a foreign exchange loss that was deemed to be a capital loss under subsection 39(2). The 2012 technical bill contained two principal changes to subsection 39(2). 23 These changes largely resolve many of the uncertainties noted above 24 and significantly narrow the type of situations to which subsection 39(2) potentially applies. deems a loss to be nil, it seems that the CRA s view is that subsection 39(2) does not apply because the taxpayer is no longer considered to have sustained (and thus cannot recognize) a loss. See, for example, CRA document nos I7, January 6, 2009; RCT , October 30, 1986; and , January 12, Kopstein and Pantry, supra note 18, at 27: The Queen v. MacMillan Bloedel Limited, 99 DTC 5454 (FCA). 23 Other changes to subsection 39(2) included non-substantive language modernization changes and the relocation of the $200 carve-out rule for individuals in a new provision (subsection 39(1.1)). 24 The changes to subsection 39(2) do not, however, clarify when, or if, the stop-loss rules are applicable to dispositions of foreign currency. Paragraph (b) of the definition of property in subsection 248(1) states that, unless a contrary intention is evident, money constitutes property for the purposes of the Act. As a result, it seems possible that in certain circumstances a stop-loss rule could potentially apply to a loss realized on the disposition of foreign currency by a taxpayer (or its foreign affiliate). For example, if a taxpayer, or its foreign affiliate, realizes a capital loss on withdrawing funds from a foreign-currency bank account to make a payment (dividend, loan repayment, etc.) to an affiliated person, a literal interpretation of the stop-loss rules in subsections 40(3.3) and (3.4) (or subparagraph 40(2)(g)(i), in the case where the taxpayer is an individual) could result in the denial or suspension of the capital loss if the foreign-currency bank account (or that of an affiliated person) is replenished with an amount denominated in the same foreign currency within the 30-day period preceding or following the particular withdrawal. The CRA s view regarding the application of the stop-loss rules to dispositions of foreign currency is not entirely clear. For example, in CRA document no I7, January 6, 2009, the CRA took the position that foreign currency did not constitute property for the purposes of the aforementioned stop-loss rules in a situation where a foreign affiliate withdrew funds from a bank account. However, in the more recent CRA document no I7, March 11, 2010 (which dealt with a situation that did not involve a foreign affiliate), the CRA seemed to imply, but did not necessarily conclude, that the stop-loss rules could apply to a disposition of foreign currency. The CRA does not appear to have publicly issued any documents discussing when, or if, the stop-loss rules are applicable to dispositions of foreign currency in the context of the changes made by the 2012 technical bill to subsection 39(2).

9 when do the stop-loss rules apply? n 569 First, subsection 39(2) was amended so that it now applies only to foreign-currency debts and similar obligations. As a result of this particular change, any foreign exchange gain or loss arising in respect of a disposition of property, including any gain or loss arising from the disposition of foreign currency, is now determined exclusively under subsection 39(1) (except where subsection 39(1.1) applies). 25 Furthermore, this change means that a corporation can no longer recognize a foreign exchange gain or loss in respect of its own shares. Consequently, the court s decision in MacMillan Bloedel has no application in the context of the amended version of subsection 39(2). Second, subsection 39(2) no longer requires all foreign exchange gains and losses to be combined into one net amount for the year. Instead, subsection 39(2) requires that a foreign exchange gain or loss be separately computed for each transaction. These changes to subsection 39(2) are generally effective for gains made and losses sustained in taxation years that begin after August 19, However, for the purposes of computing the capital gains and losses of a foreign affiliate, 26 the changes to subsection 39(2) generally apply to taxation years of the foreign affiliate that end after August 19, 2011, except that such changes may apply to taxation years of the foreign affiliate that end after June 2011 if the taxpayer timely made an election to apply certain other changes in the 2012 technical bill on a similar basis. Consequential to the amendment to subsection 39(2) to prevent the realization by a corporate taxpayer of a foreign exchange gain or loss in respect of the shares of the capital stock of that taxpayer, a corresponding change was made to paragraph 95(2)(g) in the foreign affiliate context. Paragraph 95(2)(g) generally applies for the purposes of computing the FAPI (and surplus pools) of a controlled foreign affiliate of a taxpayer or a foreign affiliate in which the taxpayer has a qualifying interest 27 throughout the taxation year ( the particular affiliate ). Under former subparagraph 95(2)(g)(ii), any income earned, loss incurred, or capital gain or capital loss realized by the particular affiliate that was caused by a 25 Subsection 39(1.1) was added, as a consequential change to the restructuring of subsection 39(2), by the 2012 technical bill and applies to dispositions of foreign currency by an individual (other than a trust). 26 Paragraph 95(2)(f ) requires a foreign affiliate s capital gain or loss from the disposition of property to be computed as if the affiliate were at all times resident in Canada, unless the context otherwise requires. Although the settlement of a debt is not a disposition of property, subsection 39(2) effectively deems there to be a disposition of currency for the purposes of computing any foreign exchange gain or loss that arises in respect thereof. Also see paragraph 95(2)(f.15), which is an interpretive rule for the purposes of applying subparagraph 95(2)(f )(i) in respect of a debt of a foreign affiliate that is described in paragraph 95(2)(i). 27 As defined in paragraph 95(2)(m). Generally speaking, a taxpayer has a qualifying interest in a particular foreign affiliate if that taxpayer owns directly or indirectly, taking into account the lookthrough rules, (1) not less than 10 percent of the issued and outstanding shares (having full voting rights under all circumstances) of the affiliate and (2) shares of the affiliate having a fair market value of not less than 10 percent of the fair market value of all of the issued and outstanding shares of the affiliate.

10 570 n canadian tax journal / revue fiscale canadienne (2016) 64:3 fluctuation in the value of a currency other than the taxpayer s tax-reporting currency 28 (that is, the Canadian dollar or such other currency as has been validly elected by the taxpayer under section 261) 29 relative to the value of that tax-reporting currency was deemed to be nil if it was earned, incurred, or realized in reference to the redemption, cancellation, or acquisition of a share of, or the reduction of the capital of, the particular affiliate or a qualified foreign affiliate 30 ( the issuing corporation ) by the issuing corporation. 31 Since a foreign affiliate is required (for the purposes of computing its FAPI and surplus pools) to compute its capital gains and losses, as well as income from property, in accordance with Canadian tax principles, 32 the aforementioned amendment to subsection 39(2) effectively meant that it was no longer necessary for paragraph 95(2)(g) to apply to foreign exchange gains and losses realized by a foreign affiliate in respect of the shares of its own capital stock. As a result, the 2012 technical bill amended paragraph 95(2)(g) (effective on the same basis as the application of the aforementioned changes to subsection 39(2)) such that it no longer applies to a redemption, cancellation, or acquisition of a share of, or a reduction of the capital of, the particular foreign affiliate. Provided that all of the other requirements of paragraph 95(2)(g) are met, subparagraph 95(2)(g)(ii) or (iii) still deems a foreign exchange gain or loss (as computed vis-à-vis the taxpayer s tax-reporting currency) of a controlled foreign affiliate of a taxpayer, or a foreign affiliate in which the taxpayer has a qualifying interest, to be 28 The term tax reporting currency is defined in subsection 261(1). 29 If a taxpayer has made a valid functional currency election under subsection 261(3), for the purposes of computing the FAPI of a foreign affiliate in respect of the taxpayer, the affiliate is effectively deemed under subsection 261(6.1) to have also made the election. In such a situation, paragraph 261(5)(h) modifies the calculating currency of the foreign affiliate in paragraph 95(2)(g) such that the affiliate must determine the application of that paragraph by reference to the elected functional currency. 30 A qualified foreign affiliate is defined in paragraph 95(2)(g) to be another foreign affiliate of the taxpayer in which the taxpayer has a qualifying interest throughout the year. 31 Subparagraph 95(2)(g)(ii). 32 Except as otherwise provided in subdivision (i) of division B of part I of the Act and except to the extent that the context otherwise requires, paragraph 95(2)(f ) deems a foreign affiliate of a taxpayer to be at all times resident in Canada for the purposes of computing, in respect of the taxpayer, the foreign affiliate s FAPI and any gain or loss arising on the disposition of capital property, whether or not such property is excluded property (as defined in subsection 95(1)) at the time of disposition. As a result, the principles associated with the computation, and the timing of the recognition, of a foreign affiliate s capital gain or loss, including section 39 and the general stop-loss rules in section 40, are relevant in computing the affiliate s FAPI and surplus pools (taking into account regulation 5907(5) where applicable). The phrase except to the extent that the context otherwise requires was added to paragraph 95(2)(f ) by Bill C-10, Budget Implementation Act, 2009; SC 2009, c. 2; royal assent March 12, Why this phrase was added is uncertain, but it seems intended to provide some subjectivity in the application of paragraph 95(2)(f ) to the extent that a clearly inappropriate result would otherwise arise in the context of the foreign affiliate legislation if the affiliate were deemed to be a resident of Canada.

11 when do the stop-loss rules apply? n 571 nil if that gain or loss arises from either (1) the redemption, acquisition, or cancellation of, or a qualifying return of capital 33 in respect of, a share of the capital stock of a qualified foreign affiliate by the qualified foreign affiliate; or (2) the disposition to a qualified foreign affiliate of a share of another qualified foreign affiliate. For example, consider the scenario illustrated in figure 1. Cdn Parent owns all of the issued and outstanding shares of Canco. Both Cdn Parent and Canco are taxable Canadian corporations, and neither of them has made a section 261 functional currency election; therefore, for both, the Canadian dollar is the tax-reporting currency. Canco owns all of the single class of issued and outstanding shares of Forco 1, which in turn owns all of the single class of issued and outstanding shares of each of Forco 2 and Forco 3. Each of Forco 1, Forco 2, and Forco 3 is (1) a foreign affiliate of Canco in which Canco has a qualifying interest and (2) a resident of a designated treaty country. 34 Forco 1 s calculating currency 35 is the US dollar, and Forco 1 s surplus pools are maintained in that currency. 36 Forco 2 has never paid a distribution in respect of its issued and outstanding shares. On December 15, 2013, Forco 1 disposes of all of its common shares in Forco 2 to Forco 3 in exchange for fair market value cash consideration of US $10 million. 37 At the time of the disposition, the shares of Forco 2 constitute capital property, 38 but not excluded property, 39 of Forco 1. There has been no change in the fair market value (or the adjusted cost base 40 [ACB]) of the shares of Forco 2, as determined by reference to the US dollar, since the time when Forco 1 acquired the shares, for fair market value consideration equal to US $10 million. The Bank of Canada noon exchange rate was US $1 = Cdn $1.1 on the date on which Forco 1 acquired the shares of Forco 2, and US $1 = Cdn $0.9 on the date on which Forco 1 disposed of the shares to Forco 3. Because the shares of Forco 2 are not excluded property of Forco 1 at the time of disposition, Forco 1 s capital gain 41 or capital loss arising in respect of the disposition 33 The term qualifying return of capital is defined in subsection 90(3). 34 As determined under regulation 5907(11.2). 35 The term calculating currency is defined in subsection 95(1). 36 Regulation 5907(6). 37 Since the consideration received by Forco 1 does not include any shares of Forco 3, paragraph 95(2)(c) is not potentially applicable to this disposition. 38 As defined in subsection 248(1). 39 As defined in subsection 95(1). 40 As defined in subsection 248(1). 41 For greater certainty, any capital gain realized by Forco 1 on the disposition of the shares of Forco 2 is computed after the application of subsection 93(1.11). Generally speaking, subsection 93(1.11) results in all or a portion of the capital gain otherwise realized by Forco 1 in respect of a disposition of the shares of Forco 2 to be treated as a deemed dividend to the extent of Forco 2 s surplus pools at the time of disposition. Since, for the purposes of this example, Forco 1 realizes a capital loss (as opposed to a capital gain) on the disposition of the shares of Forco 2, subsection 93(1.11) is not applicable.

12 572 n canadian tax journal / revue fiscale canadienne (2016) 64:3 FIGURE 1 Scenario 1 Cdn Parent Canco Canada Foreign jurisdiction Forco 1 Forco 2 Forco 3 should, for FAPI purposes, be computed using Canadian tax principles and by reference to the Canadian dollar, 42 with one-half of any such gain or loss (subject to the potential application of a stop-loss rule) being relevant in computing the FAPI and/ or FACL of Forco 1. For the purposes of computing the surplus pools of Forco 1, any capital gain or loss realized by Forco 1 on the disposition of the Forco 2 shares is, pursuant to regulations 5907(5) and (5.01), to be converted into US currency at the rate of exchange prevailing on the date on which the gain or loss arose, with onehalf of any such gain or loss being included in computing each of the exempt earnings 43 (loss) and taxable earnings 44 (loss) of Forco Prior to the application of any relevant stop-loss provision, Forco 1 realizes a loss of Cdn $2 million on the disposition of the shares of Forco 2, computed as follows: Millions of Cdn $ Proceeds of disposition (US $10 million Cdn $0.9/US $1.0)... 9 ACB of Forco 2 shares (US $10 million Cdn $1.1/US $1.0) Capital loss Paragraphs 95(2)(f ) and (f.14). 43 As defined in regulation 5907(1). 44 As defined in regulation 5907(1). 45 For greater certainty, such gain or loss should not be included in computing the hybrid surplus of Forco 1 since the shares of Forco 2 do not constitute excluded property of Forco 1. See the carve-out for FAPI gains and losses in subparagraph (ii) of elements A and B of the definition of hybrid surplus in regulation 5907(1).

13 when do the stop-loss rules apply? n 573 On the basis of the facts presented above, Forco 1 s loss is solely attributable to the fluctuation in the value of the US currency relative to the Canadian currency. Furthermore, since this loss arises from a disposition of the shares of Forco 2 (another foreign affiliate in respect of which Canco has a qualifying interest throughout the year) to Forco 3 (a third foreign affiliate in respect of which Canco has a qualifying interest throughout the year), such loss should be deemed to be nil under subparagraph 95(2)(g)(iii). 46 As a result, Forco 1 should not realize a loss in respect of this disposition for the purposes of computing its FAPI and surplus pools. A similar result would arise to Forco 1 under subparagraph 95(2)(g)(ii) if Forco 1 had instead realized such a gain or loss on a redemption, acquisition, or cancellation of, or a qualifying return of capital in respect of, the shares of Forco 2 by Forco Whereas some stop-loss provisions (such as subsection 40(3.4)) may suspend the realization of a loss, a loss that is deemed to be nil under paragraph 95(2)(g) is permanently denied. In this regard, if Forco 1 had instead disposed of the shares of Forco 2 to a person other than another foreign affiliate of Canco in which it has a qualifying interest, paragraph 95(2)(g) would not be applicable to such a disposition, although depending on the facts another stop-loss rule (such as subsection 40(3.4)) might potentially be applicable. Transitional Measures in Respect of Certain Qualifying Upstream Indebtedness One of the more significant measures included in the 2012 technical bill was the introduction of the so-called upstream loan rules in subsections 90(6) through (15). Generally speaking, and subject to certain exceptions, the upstream loan rules can potentially give rise to an income inclusion to a taxpayer resident in Canada where a loan is made by a foreign affiliate of that taxpayer to a specified debtor Since Forco 2 has not paid any dividends prior to the disposition, subsection 93(2.01) should not potentially be applicable in respect of the loss realized by Forco 1 on the disposition of the Forco 2 shares. Although it initially seems that subsection 40(3.4) could potentially be applicable to this disposition (such that the loss may be suspended rather than permanently denied), it appears reasonable to conclude that the application of subparagraph 95(2)(g)(iii) should precede that of subsection 40(3.4). Such an interpretation seems appropriate since (1) subparagraph 95(2)(g)(iii) is more specific to the context of this disposition than subsection 40(3.4); (2) paragraph 95(2)(f ) includes an except as otherwise provided in this subdivision carve-out in applying the general rule that Canadian tax principles are to be used to compute a capital gain or loss of a foreign affiliate; and (3) the preamble of paragraph 40(3.4)(b) seems to suggest that the capital loss that is deferred for the purposes of that paragraph should be calculated by first applying all of the relevant provisions (with the exception of paragraph 40(2)(g)) of the Act. By way of analogy, such an interpretation does not appear to be inconsistent with that reached in CRA document no I7, November 12, Although it seems that subsection 40(3.6) could potentially be applicable to such a disposition, at first glance it appears reasonable to conclude that the application of subparagraph 95(2)(g)(iii) may precede that of subsection 40(3.4) for reasons similar to those noted above (supra note 46). 48 As defined in subsection 90(15).

14 574 n canadian tax journal / revue fiscale canadienne (2016) 64:3 (or a specified debtor otherwise becomes indebted to a foreign affiliate of that taxpayer) and that loan or indebtedness remains outstanding for more than two years. These rules, which are effective for loans received and indebtedness incurred after August 19, 2011, were introduced by the Department of Finance to support the integrity of the existing taxable surplus regime and the new hybrid surplus regime that was included in the 2012 technical bill. The 2012 technical bill also contained certain relieving transitional measures in connection with the introduction of these new upstream loan rules. For example, the two-year repayment window otherwise allowed under the upstream loan rules 49 is effectively extended to five years for loans or indebtedness that arose before August 20, More specifically, if any portion of such a loan or indebtedness remained outstanding on August 19, 2014, that portion is deemed to be a separate loan or indebtedness that was received or incurred on August 20, 2014 in the same manner and on the same terms as the original loan or indebtedness (and is therefore subject to the normal two-year repayment window from that latter date). 50 As a result, the upstream loan rules should not apply to a loan or indebtedness arising before August 20, 2011 provided that it is fully repaid before August 20, Another set of transitional measures included in respect of the upstream loan rules is found in subsection 39(2.1) and paragraph 95(2)(g.04). These measures relate to the settlement of certain qualifying upstream indebtedness owed by a taxpayer to its foreign affiliate. Subsection 39(2.1) applies if the following conditions are met: 1. a corporation resident in Canada (or a partnership of which such a corporation is a member) ( the debtor ) has received a loan from (or became indebted to) a creditor that is a foreign affiliate of the debtor (or a partnership of which such an affiliate is a member); 2. that loan or indebtedness was outstanding on August 19, 2011 and is repaid before August 20, 2016 (that is, within the five-year repayment window discussed above); and 3. the amount of the debtor s capital gain or loss otherwise determined without regard to subsection 39(2.1) in respect of the repayment is equal to the amount of the creditor s capital loss or capital gain, as the case may be, determined in the absence of paragraph 95(2)(g.04). Where the above conditions are met, subsection 39(2.1) essentially reduces the debtor s capital gain or capital loss otherwise realized in respect of the repayment by an amount equal to the corresponding (that is, mirror image) foreign exchange capital loss or capital gain that is realized by the creditor foreign affiliate (or a foreign affiliate s share of the foreign exchange capital loss or capital gain realized by a 49 As provided by paragraph 90(8)(a). 50 Section 66(3)(a) of the 2012 technical bill.

15 when do the stop-loss rules apply? n 575 creditor partnership) on repayment of a qualifying loan or indebtedness. However, in general terms, such relief applies only to the extent that the corresponding capital gain or capital loss of the creditor affiliate (or that which is determined in respect of a foreign affiliate that is a member of a creditor partnership) would (if any such capital loss were instead a capital gain) have otherwise been included as FAPI in computing the debtor s income inclusion under subsection 91(1). 51 There is also a further requirement that such FAPI inclusion must be included in the borrower s taxation year that includes the last day of the taxation year of the creditor affiliate (or that of a foreign affiliate that is a member of a creditor partnership whose fiscal period ends in that taxation year) that includes the time of repayment. In other words, the quantum of the reduction in the capital gain or capital loss pursuant to subsection 39(2.1) is dependent upon the taxpayer s share of the foreign affiliate s FAPI. Depending on the facts, a debtor s capital gain or capital loss otherwise realized in respect of a repayment could be reduced by an amount up to that capital gain or capital loss. Paragraph 95(2)(g.04) is a companion rule to subsection 39(2.1) that is relevant in computing the FAPI and surplus pools 52 of a foreign affiliate. Pursuant to paragraph 95(2)(g.04), a capital gain or loss otherwise realized by a foreign affiliate (or a partnership of which such an affiliate is a member) of a corporation resident in Canada (or a partnership of which such a corporation is a member) in respect of a repayment, in whole or in part, of a loan or indebtedness owing by that corporation (or that partnership) is generally deemed to be nil if such gain or loss is equal to the mirror image of the debtor s capital gain or loss (determined in the absence of subsection 39(2.1)). Similar to subsection 39(2.1), paragraph 95(2)(g.04) applies to a qualifying loan or indebtedness that was outstanding on August 19, 2011 and repaid before August 20, These measures are generally intended to be relieving in nature, insofar as they may (under certain circumstances) fully or partially mitigate adverse foreign exchange implications that would otherwise arise on the repayment of upstream loans to avoid the potential application of subsection 90(6). Furthermore, these measures can also function as stop-loss rules to deny a foreign exchange loss that is otherwise recognized upon the settlement of certain qualifying upstream indebtedness. However, it should be noted that the relief provided by these measures is likely quite limited For these purposes, this hypothetical FAPI inclusion to the debtor is determined on the basis of certain assumptions or adjustments. For example, (1) it is assumed for the purpose of this determination that the creditor has no other income, loss, capital gain, or capital loss in any year; and (2) if a capital loss would have otherwise been realized by the foreign affiliate on the settlement of the qualifying loan or indebtedness, such loss is deemed to be a capital gain for these purposes. 52 Paragraph 95(2)(g.04) should apply for the purposes of computing the surplus pools of the foreign affiliate by virtue of regulation 5907(5). Regulation 5907(5) provides that, for the purposes of regulation 5907, each capital gain, capital loss, taxable capital gain, or allowable capital loss of a foreign affiliate of a taxpayer from the disposition of property is to be computed in accordance with the rules set out in subsection 95(2). 53 For greater certainty, these measures are generally relevant only if the particular loan or indebtedness is denominated in a currency other than the Canadian-resident corporation s

16 576 n canadian tax journal / revue fiscale canadienne (2016) 64:3 For example, relief under these measures is potentially available for the repayment of a loan or indebtedness between a corporation resident in Canada (or a partnership of which such a corporation is a member) and a foreign affiliate (or a partnership of which such an affiliate is a member) of that corporation (or partnership) only to the extent that the debtor would otherwise include in computing its taxable income the FAPI (that is, the foreign exchange gain or loss) that arises to an affiliate in respect of the repayment. Accordingly, using the structure depicted in figure 1 as an illustration, relief would potentially be available in respect of a qualifying upstream loan (or indebtedness) between Forco 1 and Canco, but no relief would be available if instead that loan (or indebtedness) were between Forco 1 and Cdn Parent. 54 Similarly, subsection 39(2.1) and paragraph 95(2)(g.04) apply only if the foreign exchange gain or loss otherwise realized by each of the debtor and the creditor in respect of the repayment is on account of capital. Thus, if a foreign exchange gain or loss realized by either of the debtor or the creditor is on account of income, relief is not available. Even if this characterization requirement is met, these measures apply only if the debtor s foreign exchange gain or loss exactly mirrors the corresponding foreign exchange loss or gain that is realized by the creditor. 55 In this regard, there could be a number of instances where this might not be the case. Consider, for instance, a scenario based on figure 1 whereby Forco 1 made a US dollar denominated, non-interest-bearing loan to Canco on February 1, Assume that this loan was repaid by Canco on February 1, 2015 and the foreign exchange gain or loss arising to Canco and Forco 1 in respect thereof is on account of capital. If, during the period when this loan was outstanding, the US dollar depreciated in value relative to the Canadian dollar, on repayment Canco should realize a foreign exchange gain and Forco 1 should realize a foreign exchange loss. At first glance, it tax-reporting currency (which, in the absence of a section 261 functional currency election, is the Canadian dollar). If the loan is denominated in Canadian dollars and the Canadian dollar is also the taxpayer s tax-reporting currency, there is no need for relief because there should not be any foreign exchange gain or loss realized (for Canadian tax purposes) by either the debtor or the foreign affiliate for which relief is required. Pursuant to paragraph 95(2)(f.14), a foreign affiliate of a taxpayer is typically required to compute its FAPI, which generally includes any capital gain or capital loss realized on repayment of an indebtedness of a resident of Canada, by reference to the taxpayer s tax-reporting currency. 54 Although Forco 1 is both a foreign affiliate and a controlled foreign affiliate of Cdn Parent, the mechanics of subsection 91(1) and the definition of participating percentage in subsection 95(1) are such that Canco (as opposed to Cdn Parent) is the only taxpayer that includes in computing its taxable income any FAPI earned by Forco In CRA document no C6, May 28, 2015, the CRA indicated that it is possible, assuming that all of the conditions of subsection 39(2.1) are otherwise met, for the matching requirement to be met in respect of a foreign exchange gain or loss that otherwise arises in respect of a qualifying indebtedness of a taxpayer to its foreign affiliate where that indebtedness arose before the taxpayer made a functional currency election under section 261 and the indebtedness was repaid after the effective date of such election, provided that the taxpayer and the foreign affiliate have the same year-end.