4 September 2014 Global Tax Alert News from Americas Tax Center EY Americas Tax Center The EY Americas Tax Center brings together the experience and perspectives of over 10,000 tax professionals across the region to help clients address administrative, legislative and regulatory opportunities and challenges in the 33 countries that comprise the Americas region of the global EY organization. Copy into your web browser: http://www.ey.com/us/en/ Services/Tax/Americas-Tax- Center---borderless-clientservice Canada s Department of Finance releases draft financial services tax measures Executive summary On 29 August 2014, Canada s Department of Finance released certain legislative proposals stemming from the February 2014 budget and earlier. Of particular relevance to the financial services industry are rules: Expanding the scope of foreign accrual property income (FAPI) rules 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 Restricting the application of the regulated financial institution exception for purposes of the investment business definition Modernizing the life insurance policy exemption test Allowing the use of partnership holding structures in the FAPI exception rules when deriving income from trading or dealing in indebtedness Interested parties are invited to provide their comments by 28 September 2014. Detailed discussion Insurance swap or similar arrangements The proposed legislation was originally set out and first introduced as part of the February 2014 budget to expand the FAPI rules to capture the insurance or reinsurance of arm s-length non-canadian risks where there is an insurance swap or similar arrangement that results in the affiliate s economic exposure being determined by reference to Canadian risks. The latest proposal is very much the same as the original release. This measure applies to taxation years of a taxpayer that begin on or after 11 February 2014.
Though often referred to as being directed at captive insurance arrangements, the proposed legislation is most accurately described as targeting insurance swaps. Unaffected are many variations of captive insurance arrangements that insurers use in managing bona fide risks that do not include the use of insurance swaps. The Canadian foreign affiliate system contains various antiavoidance rules that are designed to prevent taxpayers from shifting certain Canadian-source income to foreign affiliates. When these rules apply, such income earned by a controlled foreign affiliate is considered foreign accrual property income and is taxable in the hands of the Canadian taxpayer on an accrual basis. The specific anti-avoidance rule in paragraph 95(2)(a.2) is intended to prevent Canadian taxpayers from shifting income from the insurance of Canadian risks to foreign affiliates. The proposed legislation extends the application of the rules in paragraph 95(2)(a.2) to arrangements (i.e., insurance swaps) under which a foreign affiliate insures a foreign policy pool (i.e., a pool of foreign risks) but has either alone or together with non-arm s-length persons economic exposure to relevant Canadian risks by virtue of a tracked policy pool. If the economic exposure (i.e., the risk of loss or opportunity for gain) in respect of the foreign policy pool (including the economic exposure of the affiliate and non-arm s-length persons from the agreements or arrangements) can be tracked to the actual tracked policy pool, the proposed legislation deems this foreign policy pool to be in substance insuring Canadian risk. The proposed legislation includes a de minimis test that must be analyzed for each tracked policy pool independently. The de minimis test is based on a 10% threshold of Canadian risks. If the above conditions are satisfied, proposed paragraph 95(2)(a.22) deems activities performed in connection with the insurance swap also to be FAPI (including income that is incidental or pertains to the business). While there is no doubt as to the type of targeted transactions, there are still uncertainties as to the meaning and scope of proposed paragraph 95(2)(a.2). For example, could a derivative transaction be considered a form of insurance of Canadian risk and therefore caught in the FAPI net per proposed paragraph 95(2)(a.2)? Consider a Canadian corporation wanting to enter into a derivative transaction with respect to a Canadian asset. Rather than enter into that derivative directly, it could be executed instead by a foreign affiliate. Could potentially the gain on that derivative be viewed as a form of insurance on Canadian risk and therefore now FAPI? Definition of investment business The proposed legislation includes additional conditions for the application of the investment business definition for FAPI purposes, applicable to taxation years of a taxpayer 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). The first new condition in the form of proposed paragraph 95(2.11)(a) requires 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 particular corporation that is a regulated Canadian financial institution (defined for this purpose to mean a Schedule I bank, a trust company, a credit union, an insurance corporation or a trader or dealer in securities or commodities that is resident in Canada, and carries on a business the activities of which are supervised by the Superintendent of Financial Institutions or a similar provincial regulator) A subsidiary wholly-owned corporation of such an institution A corporation that wholly owns such an institution (and is also subject to regulation) 2 Global Tax Alert Americas Tax Center
A corporation resident in Canada, each of the shares of which is owned by a corporation described in the above A partnership each member of which is a corporation described above We are pleased that paragraph 95(2.11)(a) has been expanded from the original proposal to contemplate a holding company structure, for example those that arose out of demutualization of insurers. However, potential pitfalls remain. Although the proposals allow for a foreign minority interest in a foreign affiliate, the presence of a minority interest in a Canadian corporation within the ownership chain would cause the income of a downstream foreign financial institution to be subject to the FAPI regime, regardless of their activities or operations. Further, paragraph 95(2.11)(a) prevents an otherwise unregulated third party from benefiting from the regulated foreign financial institution exception through the use of special or tracking shares of a particular corporation. The particular corporation cannot have outstanding, at any time during the period, a class of shares the fair market value of which is determined by reference to (i.e., tracks) any of certain criteria (fair market value of, any revenue, income or cash flow from, any profits or gains from the disposition of, or any other similar criteria) for underlying property where the fair market value of the underlying property is less than 90% of the fair market value of all property of the corporation. To reinforce the intent of the exception proposed for regulated financial institutions, an arbitrary size test has been introduced as part of paragraph 95(2.11)(b). To ensure that the larger Canadian financial institutions are not impacted, the paragraph is intended for entities regulated under the Bank Act, the Trust and Loan Companies Act or the Insurance Companies Act with at least $2 billion of equity. Alternatively, where it is established that more than 50% of the taxable capital of the taxpayer or related Canadian group is attributable to a regulated business, the condition is also met. Life Insurance exemption test Included in the 29 August 2014 legislation proposals are updates to the life insurance exemption test or the exempt test to determine the application of accrual taxation to life insurance policies. This release is similar to proposals originally released for comment on 23 August 2013 and comes after several years of discussion with the life insurance industry. As described by Finance, the proposals are intended to reflect the modernizing of the life insurance policy exemption test and to eliminate perceived abusive opportunities by addressing current economic assumptions. The rules as originally drafted did not contemplate the wide range of options inherent in current life insurance policies, in particular universal life. The proposed rules would take effect for policies issued after 2016 or which no longer maintain grandfathered status. Life insurers will be required to maintain several generations of grandfathering and to be able to identify those policy changes which result in a loss of grandfathering. The proposals will have a significant impact on the life insurance industry and consumers in Canada, including: An increase in the Part XII.3 Tax on Investment Income of Life Insurers, particularly on universal life policies, which received favorable treatment under the existing rules The potential need to redesign and reprice existing insurance contracts to reflect the additional tax costs as well as to ensure new products maintain their taxexempt status Significant investment by the life insurance industry to update administration systems and processes to reflect the new rules While the exempt test maintains most of its basic elements, virtually all the assumptions used in the tests will undergo some level of change. The impact of these changes will vary by product and insurer. Global Tax Alert Americas Tax Center 3
Among the more significant changes included in the proposals are: The introduction of more recent mortality tables for determining the capital element of annuity payments (Annuity 2000 Basic Mortality Table) and the net cost of pure insurance (CIA 1986-92) Updating and standardizing assumptions used in determining the exempt status of life insurance policies Changes impacting the maintenance of policy ACBs and certain taxable dispositions The introduction of a specific anti-avoidance rule for life insurance policies in order to limit future potential abusive tax planning. Trading or dealing in certain indebtedness Generally speaking, income derived principally from trading or dealing in certain indebtedness by a foreign affiliate is subject to the FAPI rules by way of paragraph 95(2)(l), unless particular exemptions are met. Generally, the FAPI rules do not apply if the affiliate is a regulated foreign bank or similar financial institution and is an affiliate of a regulated Canadian financial institution. For taxation years that begin after 2014, the legislative proposals contain an extension of the exception from the application of paragraph 95(2)(l) to foreign affiliates held through a partnership, provided that each member of the partnership is a regulated Canadian financial institution. 4 Global Tax Alert Americas Tax Center
For additional information with respect to this Alert, please contact the following: Ernst & Young LLP (Canada), Toronto Reya Ali-Dabydeen +1 416 943 2220 reya.ali-dabydeen@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 Gail MacLeod +1 416 943 2025 gail.macleod@ca.ey.com Jayshree Govind +1 416 941 1849 jayshree.h.govind@ca.ey.com Mal Leighl +1 416 943 3986 malkit.leighl@ca.ey.com Mark Stevens +1 416 943 3217 mark.stevens@ca.ey.com Martin Wickins +1 416 943 2598 martin.wickins@ca.ey.com Russ Lavoie +1 416 943 2295 russ.lavoie@ca.ey.com Shannon McLaughlin +1 416 943 2155 shannon.e.mclaughlin@ca.ey.com Ernst & Young LLP (Canada), Vancouver Mike Vantil +1 604 891 8315 michael.p.vantil@ca.ey.com Global Tax Alert Americas Tax Center 5
EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Americas Tax Center 2014 EYGM Limited. All Rights Reserved. EYG No. CM4699 This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com