2014 Issue No. 56 28 October 2014 Tax Alert Canada Insurance swaps and offshore banking arrangements: Bill C-43 (2014) EY Tax Alerts cover significant tax news, developments and changes in legislation that affect Canadian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. On 23 October 2014, Bill C-43, Economic Action Plan 2014 Act, No. 2, received first reading in the House of Commons. Bill C-43 includes certain tax measures announced in the 2014 federal budget and earlier with respect to insurance swaps and offshore banking arrangements. Of particular relevance to the financial services industry are rules that: Expand the scope of the foreign accrual property income (FAPI) regime to capture the insurance or reinsurance of arm s-length non-canadian risk where there is an insurance swap or similar arrangement that results in the affiliate s economic exposure being determined by reference to Canadian risks Restrict the application of the regulated financial institution exception for purposes of the investment business definition Modernize the life insurance policy exemption test Allow the use of partnership holding structures in the FAPI exception rules when deriving income from trading or dealing in indebtedness. These amendments are somewhat unclear and very broadly worded. In this Tax Alert, we discuss some of the hurdles associated with the insurance swaps and offshore banking arrangement amendments. Insurance swaps In the 2014 federal budget, Finance identified the so-called insurance swap as a sophisticated tax-planning arrangement that they believe circumvents a specific
anti-avoidance rule in the FAPI regime aimed at preventing base erosion. An insurance swap refers to an arrangement entered into by an affiliate of the taxpayer under which Canadian risk is exchanged for foreign risk and the economic returns under the arrangement are the same as if the affiliate had not entered into the insurance swap. Finance has introduced very broad wording in the proposed legislation to ensure that the profits on such insurance swaps will be included in the computation of FAPI. To determine the required economic linkage, Bill C-43 has introduced a forward-looking test based on the risk of loss or opportunity for gain or profit in respect of the agreements or arrangements. This test includes various criteria for establishing linkages between the two pools of risks, including the fair market value of, the revenue, income, loss or cash flow from, or any similar criteria. A common form of insurance swap relates to reciprocal reinsurance. Reciprocal reinsurance is a type of reinsurance used by insurance entities to diversify their risk without significantly decreasing their profitability. For example, one insurer may have too much Calgary flood risk while another may have too much tornado risk in the US Midwest. By swapping their excess risks there is a decreased chance that either will fail during a catastrophe. Reciprocal reinsurance can be done with local, national, international or global risks and routinely crosses borders. Even though the expectation of profit on risks ceded and assumed in respect of reciprocal reinsurance may be similar, when a catastrophe occurs the profits of the two insurers will be significantly different. However, on a prospective basis before a catastrophe occurs, the revenue, profit and cash flow projections would be very similar. This common business transaction, undertaken to mitigate and diversify risk, may now be caught by the new rules. For example, a Canadian insurer may reinsure its third-party risks offshore where they have the requisite expertise to manage the risk (along with the global risk of their subsidiaries). The offshore entity may decide to reinsure all or a portion of its Canadian risk, retain its Canadian risk or enter into a reciprocal reinsurance with a third party to manage its concentration of Canadian risk. This important tool to manage risk may be caught by Bill C-43, which may create a significant tax disadvantage to Canadian-controlled entities while not impeding foreign players (i.e., creating a competitive disadvantage to Canadian multinationals). Changes to the definition of investment business Bill C-43 also includes additional conditions for the application of the investment business definition for FAPI purposes, applicable to taxation years that begin after 2014. The proposals ensure that the exception for a regulated foreign financial institution is only available to taxpayers that can establish themselves as primarily a regulated Canadian financial institution or a taxpayer that is part of such a group. The definition in paragraph 95(1)(a.1) extends the regulated foreign financial institution exception such that a foreign affiliate is required to satisfy two additional conditions, introduced as paragraphs 95(2.11)(a) and (b). Finance s intent regarding registered securities dealers Included in the first new condition in proposed paragraph 95(2.11)(a) is a requirement that throughout the period the taxpayer (i.e., the Canadian taxpayer of which the foreign corporation is a foreign affiliate) must be one of the following: a Schedule I bank, a trust company, a credit union, an insurance corporation or a trader or dealer in securities or commodities that is a registered securities dealer that is resident in Canada. [emphasis added] The explanatory notes indicate that the registered securities dealer requirement is intended to ensure that only bona fide traders or dealers in securities that is, traders or dealers Insurance swaps and offshore banking arrangements: Bill C-43 (2014) 2
that carry on a substantial business of acting as an intermediary with respect to transactions in securities by their clients, and therefore require registration qualify for the regulated foreign financial institution exception in the investment business definition. It is unclear whether meeting the requirements in the definition of registered securities dealer will be sufficient to meet the goal of carrying on a substantial business (not a defined term), as no reference to substantial business is made in the proposed subsection 95(2.11) provision itself. From reading the explanatory notes (which are not binding in a court of law), it appears that Finance is of the view that only a real/full-time securities dealer (i.e., bona fide) would qualify as a registered securities dealer, as opposed to part-time individuals trading in securities that do not represent their active business and are not registered. The $2-billion threshold in paragraph 95(2.11)(b) Finance has used various thresholds in the Income Tax Act to indicate what qualifies as a large corporation for the purposes of different provisions. In 2007, Finance amended subsection 190.15(1) to increase the capital deduction threshold for financial corporations to $1 billion. This threshold hasn t been amended since. It is unclear why a similar threshold was not used for the test in proposed paragraph 95(2.11)(b), but rather they selected $2 billion of equity as the threshold (i.e., a somewhat arbitrary threshold). Our largest financial institutions are all in excess of the $2-billion threshold. However, there are significant banks, insurers and trust companies that do not meet this threshold. The proposed rule does not encourage these regional and national companies to expand outside of Canada. Further, if these entities are too successful outside of Canada their operations may be subject to immediate taxation in Canada (i.e., if the taxable capital test would not be met). Taxable capital test, where a corporation does not meet the $2b equity test Where a taxpayer does not meet the $2 billion test described above, the proposed legislation provides a second alternative test that must be met. In particular, the condition in paragraph 95(2.11)(b) may be met if more than 50% of the taxable capital employed in Canada of the taxpayer, or of a related entity, is attributable to its regulated business carried on in Canada (analogous to the requirements to be a qualified small business corporation share ). There is some ambiguity in the drafting of this proposed legislation. It may be inferred that the 50% test is based only on an entity that is carrying on a regulated business (such as the entity that meets one of the conditions in (a)). However, an alternative approach to interpret and apply this test is to look at the total taxable capital of all related Canadian entities. Both of these alternative approaches have merit based on a textual, contextual and purposive approach to applying the proposed provision. Proposed paragraph 95(2.11)(b), uses the words the taxpayer or of the affiliated corporation, as the case may be. The use of as the case may be seems to be consistent with the interpretation that only one entity must meet the 50% test. Further, since the requirements in paragraph (a) may be met by having a single Canadian regulated entity, this interpretation and application of paragraph (b) would provide a consistent reading of the provision as a whole. One possible extension of this interpretation would be to allow conglomerates of financial and non-financial businesses to expand their financial services business overseas if they have a strong current Canadian presence. However, that may not be the intent of the proposed section. If Finance is concerned that certain individuals and corporations are abusing the exceptions to the investment business definition, and if Finance intends that the related group must be primarily in the financial services business in Canada before they can receive the benefit of the exemption to the investment Insurance swaps and offshore banking arrangements: Bill C-43 (2014) 3
business definition, then the latter interpretation may be the intended result (i.e., to examine the total taxable capital of all related Canadian entities in applying the 50% test). Learn more For more information, contact your EY or Couzin Taylor advisor or one of the following professionals: Reya Ali-Dabydeen +1 416 943 2220 reya.ali-dabydeen@ca.ey.com Martin Wickins +1 416 943 2598 martin.wickins@ca.ey.com Asif Rajwani +1 416 943 2626 Asif.Rajwani@ca.ey.com Jillian Nicolson +1 416 943 4474 Jillian.Nicolson@ca.ey.com Diamada Yannopoulos +1 416 943 3975 diamada.yannopoulos@ca.ey.com Gail MacLeod +1 416 943 2025 gail.macleod@ca.ey.com Santosh Prasad +1 416 943 5433 santosh.prasad@ca.ey.com Russ Lavoie +1 416 943 2295 russ.lavoie@ca.ey.com Jayshree Govind +1 416 941 1849 jayshree.h.govind@ca.ey.com Shannon McLaughlin +1 416 943 2155 shannon.e.mclaughlin@ca.ey.com Antonella Pavia +1 416 943 3531 antonella.pavia@ca.ey.com George Guedikian +1 416 943 3878 george.b.guedikian@ca.ey.com Benoît Millette +1 514 879-3562 benoit.millette@ca.ey.com Matt MacInnis +1 416 943 3991 matthew.macinnis@ca.ey.com Joe Micallef +1 416 943 3494 joseph.n.micallef@ca.ey.com Craig Bates +1 416 943 3323 craig.bates@ca.ey.com Doris Foo +1 416 943 2232 doris.foo@ca.ey.com Mark Stevens +1 416 943 3217 mark.stevens@ca.ey.com Mike Vantil +1 604 891 8315 michael.p.vantil@ca.ey.com Mal Leighl +1 416 943 3986 malkit.leighl@ca.ey.com Insurance swaps and offshore banking arrangements: Bill C-43 (2014) 4
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